the PIMCO Total Return Fund
February 23, 2010
Understanding the risks and opportunities
The Total Return fund is actively managed against the Lehman/Barclay AGG index, and it achieves its alpha through sector selection, yield curve positioning, individual security selection, leverage, and use of derivatives. The following illustrates the sector selections of the fund over the last two years:
High-yield and emerging market bonds are not part of the AGG index, and the fund’s exposure to these sectors may explain some of its outperformance against its benchmark.
Truly understanding the risks in this fund is beyond the average advisor and certainly beyond virtually all individual investors. The fund’s most recent quarterly statement is over 100 pages, devoted mostly to a list of its holdings – US and foreign government bonds, mortgage-backed securities, credit default swaps, futures contracts, interest rate swaps and swaptions, and foreign currency contracts.
On your own, you would have as much chance of understanding the risks and opportunities in those holdings after perusing this statement as you would successfully performing brain surgery after watching an episode of Grey’s Anatomy. If you insist on fully understanding the risks in your investments – a perfectly reasonable attitude – this fund is not for you.
Indeed, many advisors reject the fund for its lack of transparency, a concern that has been prominently portrayed by many in the financial media. Since I believe this concern is largely misplaced, let’s examine how advisors can overcome perceived risks related to the fund’s opacity.
Karen Dolan, the director of fund analysis at Morningstar, said in a recent interview that investing in the fund requires “a little bit of a leap of faith.”
Advisors can take that leap by using research from firms like Morningstar, which has followed the fund since its inception. Eric Jacobson is Morningstar’s lead analyst for this fund, and when I spoke to him last week he had just returned from a meeting with the fund’s management team. He explained that the fund uses tools, like derivatives, that in the wrong hands can amplify risk. “PIMCO uses them liberally,” he said. “They are one of a handful of fund managers who have proven they can handle that responsibility.”
“It’s very difficult for an outsider to mathematically analyze the portfolio from the raw data without having PIMCO give the data to you and say this is what it means,” he said. Nonetheless, he is confident it is not an overly aggressive portfolio. It does not use high degrees of leverage or exposure to volatile sectors like emerging markets and high-yield bonds, Jacobson said.
Advisors have less access to Gross than with most active fund managers. Most of the communication from Gross comes through his periodic commentaries published on PIMCO’s web site and his frequent appearances on CNBC and elsewhere in the media. He occasionally meets with advisors at PIMCO’s offices and holds conference calls with advisors. Gross declined to be interviewed for this article.
PIMCO, though, shares more information than many of its peers, and it provides detailed, quantitative profiles of the fund to advisors. Making sure one understands that information and asks the right questions is the challenge, Jacobson said. For example, advisors should ask why and how PIMCO is using derivatives, and how they might contribute to risk in the portfolio, he said.
Maryland-based Fortigent, LLC provides consulting and investment management services to over 70 advisory clients, and those clients own approximately $250 million of the fund. Adam Cohen directs fixed income research at Fortigent and relies on many of the same sources of information as Jacobson. Relative to the other fixed income funds he follows, he said, PIMCO provides better information about the fund’s position on the yield curve, its sector and duration positioning, and other factors.
“One of our biggest worries about the fund is its use of derivatives,” which are susceptible to counterparty risk, Cohen said.
“The reality is that for the really deep due diligence, we are smart enough to rely on firms like Fortigent and [the California-based research firm] Litman Gregory,” Jim McGurren of New York-based Dartmouth Advisory told me. “You have to pay close attention to their commentaries to understand their thinking and philosophy.” McGurren’s clients have significant exposure to the fund.
Harold Evensky of Florida-based Evensky & Katz uses the Total Return fund, and, as he does with other fixed income funds he considers, he looks primarily at duration and quality, then at other factors like turnover and volatility. “Because it is so actively managed and sophisticated, I can’t say we completely grasp its very complex management,” he said. Nonetheless, he doesn’t believe there are “any embedded time bombs I don’t understand.” The fund is part of his core fixed income component, filling out the higher duration segment of his laddered interest rate position. He typically holds about 3% of clients’ assets in the fund; the bulk of his fixed income positions, which comprise 40% of most portfolios, are in short- term maturities.
Steve Lee, of Pittsburgh-based H.L. Zeve & Co., has approximately $21.5 million of client assets in the fund. He is concerned about derivatives and leverage and, like the other advisors I spoke with, he is confident that PIMCO’s managers are sufficiently skillful to properly use them. “Their long-term track record backs this up,” he said.Display article as PDF for printing.
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