the PIMCO Total Return Fund
February 23, 2010
Is the fund too big?
Our survey showed that advisors consider the fund’s size to be its greatest source of risk. Size restricts the fund’s opportunity set and can limit its ability to quickly shift direction in response to changes in the macro environment. Some of the advisors I spoke with voiced this apprehension.
McGurren, for instance, is most worried about the size of the fund, but he finds comfort in the depth and liquidity of the markets. Nonetheless, he said that PIMCO could get caught “flatfooted” by an abrupt change in the economy or the market, and the fund’s performance might lag in such an environment.
“The bigger you get, the harder it is for positions to have an impact on the portfolio,” Zeve’s Lee said.
At $200 billion, the fund’s assets represent approximately 0.03% of the $648 trillion that make up the global debt markets, including the cash bonds, OTC derivatives, and exchange-traded futures and options, based on Q1 2009 data provided by PIMCO.
Of that $648 trillion, $510 trillion represents the notional value of the OTC derivatives market, so the fund’s size relative to the size of exchange-traded securities is much greater. Excluding the derivatives market, the fund’s assets represent 0.15% of its investible universe. That is roughly the same percentage as a $20 billion US equity fund, relative to the market capitalization of the US equity market, and about one-quarter to one-third the size of the largest actively managed US equity funds, such as Fidelity’s Contrafund.
It is not just the fund’s assets that matter, though. PIMCO manages nearly $1 trillion in assets and, if PIMCO’s perceptions of market opportunities change, asset flows across all its funds could be constrained.
Interest rates and inflation
On balance, I agree with those who consider concerns about a lack of transparency and the use of derivatives to be red herrings. It wasn’t derivative contracts per se that contributed to the financial crisis; it was their improper use, and PIMCO’s managers have amply demonstrated their expertise.
I am less worried than most about the fund’s size. Its position relative to the exchange-traded markets is relatively modest. The bond markets are far more homogenous than the equity markets. Although the fund may be constrained in its ability to take positions in individual securities, its ability to move across sectors is unlikely to face limits, at least at its current size.
But interest rate risk is another story.
“We are very concerned about interest rates and inflation,” Evensky told me.
I agree. It is those twin concerns that deserve the lion’s share of our attention.
“We are not overly scientific in our analysis of the fund,” Zeve’s Lee told me, “but what really worries us the most about fixed income today is the impact of rising interest rates.” He believes inflation is not a big deal for now, but “you don’t have to be an economist to see that interest rates have nowhere to go but up,” he said.
Our survey showed that advisors forecast a 150-plus-basis-point increase (to 5.28%) in the 10-year rate over the next three years, and they forecast an average CPI-U inflation rate of 3.29% over that time period.
If that forecast is accurate, the price of a constant-maturity 10-year Treasury bond will decline approximately 12% over that period. The 10-year bond has a longer duration (approximately 8) than the target duration of the fund (between 4 and 6), so the fund’s exposure to rising rates, based on the current shape of the yield curve, is smaller. Also, that 12% decline would be partially offset by coupon income and reinvestment income on those coupons.
It would be a mistake to translate this 12% headwind directly into a projection of performance for the fund. The fund’s managers have an arsenal of tools to combat rising interest rates. They are surely focused on these concerns and have already signaled that they are taking steps, such as increasing the fund’s position the German bond market, to mitigate interest rate risk. Other tools to defend against rising rates include shifting duration outside the US or positioning along the yield curve, and the ability to reinvest coupons at higher rates.
Since the inception of the fund in 1987, there have been four major tightening cycles (involving the Fed Funds rate) by the Fed. In three of those four cycles, the fund generated positive alpha and positive cumulative return.
The due diligence that advisors perform on this fund should undoubtedly focus on the questions of how the fund will perform under different interest rate environments and how effectively its managers can defend against rising rates. Advisors should understand the parallels between those four tightening cycles and today’s environment and, in particular, how long-term rates behaved in those cycles.
“Gross has a reasonably good chance of outperforming other funds through a cycle, but that doesn’t mean he can sidestep interest risk,” Morningstar’s Jacobson said. If you are in the camp that forecasts higher interest rates, he said, you would be better off in an asset allocation fund or one of PIMCO’s unconstrained funds.
Given advisors’ inflation forecasts, one alternative are inflation-protected bonds. The (real) yield on 10-year TIPS is approximately 1.50%. Add to that projected inflation of 3.29%, and their projected return is 4.79% – which will be tough for any fixed-rate fund to beat, given advisors’ forecasts. (This calculation assumes that real yields remain constant. In a period of rising rates, real rates might rise. On the other hand, rising inflation could increase the demand for TIPS, lowering real rates. The limited historical data for TIPS provides insufficient data to accurately forecast real yields.)
The Total Return fund does not currently hold any inflation-protected securities.
Lee worries about how he will explain to clients when the NAV of a fund declines in response to declining rates. “Our biggest worry is to keep folks from reacting improperly from perceived bad events,” he said.
The Total Return fund is not unique – exposure to rising rates is a concern for any fixed-rate bond fund. The question is not whether to be in such a fund, since nobody can forecast interest rates precisely, but how much exposure one should have.
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