As a retiree I have been drawn to PIMCO's bond funds due to their excellent reputation. PIMCO has an extensive lineup and often the same manager will be in charge of both open ended mutual funds and closed end funds. I have received several comments from retirees inquiring as to which PIMCO offering is better: mutual funds or CEFs. PIMCO's wide array of different funds provides a unique opportunity to compare mutual funds against CEFs with similar investment objectives. This article will review several PIMCO funds and assess their risk-adjusted returns over multiple time frames.
However, before looking at specific funds, I will provide a quick review of some of the difference between mutual funds and closed end funds.
A closed end fund (CEF) is created when an investment company decides to raise a pool of money by selling a fixed number of shares in an Initial Public Offering (IPO). The public buys stock in the newly formed fund, with each share representing a proportional ownership in the investments that have been purchased with the IPO pool of money. Note that the number of shares is fixed. The value of the securities that the fund holds is called the Net Asset Value (NAV). However, the actual price of the stock associated with the closed end fund depends on the market forces of supply and demand. If there is a large demand for the stock, the price increases and may even rise above the NAV. If this happens, the CEF is said to sell at a premium. Similarly, the supply of shares offered for sale may be greater than the demand and the stock may sell at a discount to NAV. The shares of the CEF can be bought or sold throughout the trading day, just like any other stock.
By contrast, a mutual fund (also called an open ended fund) does not have any restrictions on the number of shares the fund will issue. At the end of the day, the mutual fund buys back shares at the NAV from investors that wish to sell. If there are more buyers than sellers, the fund will issue more shares so that demand always equals supply. Therefore, open end funds sell at the NAV (calculated at the end of each day after the market is closed); there is never any discount or premium. Shares of mutual funds can only be purchased or redeemed at the end of each day.
At PIMCO, Bill Gross manages both mutual funds and CEFs. Mr. Gross is recognized as the "Bond King" and was one of the founders of PIMCO in 1971. He is a titan in the world of fixed income securities. The funds he manages include:
- PIMCO Total Return D (PTTDX). This is the largest mutual fund in the world with more than $250 billion in assets. Note that this fund consists of several different investment classes that have basically the same portfolio but slightly different yields and expenses. The fund has grown over the years due to a long record of outperformance with only a few miscalculations along the way. The fund will make significant interest rate and yield curve plays based on the macro judgments of the investment team. The fund also typically makes more use of derivatives than other bond mutual funds. The portfolio is a mixture of treasuries (including inflation protection), corporate bonds, and mortgage backed securities. Most securities are from US firms but about 15% are international. Effective duration is a relatively short 4.7 years. The fund yields 3.6% and has an expense ratio of 0.75%.
- PIMCO Corporate and Income (PTY). This CEF currently sells at a premium of 6.5%, which is low compared to the 52 week average premium of almost 18%. The fund has a high distribution of 9.14%, which has been achieved without return of capital (ROC). The fund's 353 holdings have a focus on corporate bonds but also invests in a wide variety of assets including floating rate loans, asset backed bonds, and a few preferred stocks. About 30% of the holdings are investment grade. The fund utilizes about 21% leverage and also uses derivatives to manage risks and increase returns. Bill Gross owns more than $1 million in shares of this fund. The leverage adjusted duration in around 6 years and the expense ratio is 1%.
- PIMCO Income Strategy fund (PFL). This CEF sells at a premium of 1.8%, which is below the average premium of 5%. This distribution rate is 9.4%, which has been achieved without ROC. The fund holds 353 securities that are distributed among floating rate loans, asset backed bonds, corporate bonds, and a few preferred stocks. Note that in 2010, the fund shifted focus from floating rate loans to a multi-sector bond fund. About 68% of the holdings are investment grade. Bill Gross also owns more than $1 million in shares of this fund. The fund utilizes about 22% leverage and also uses derivatives to manage risks and increase returns. The expense ratio is a relatively high 1.9%, including interest payments.
- PIMCO Income Strategy Fund II (PFN). This CEF sells at a 1% premium, which is low when compared with an average premium of over 4%. The fund has a high distribution of 9.5% without any return of capital. The portfolio of 280 holdings is divided over a wide range of investments including corporate bonds (investment grade and high yield), asset backed bonds, municipal bonds, preferred stocks and floating rate debt. About 75% of the portfolio is investment grade. Like PFL, the fund shifted focus in 2010 from floating rate loans to a multi-sector strategy. Although this fund has a similar composition as PFL, the two funds were only 82% correlated over the past 5 years. The fund also uses derivatives to enhance return and provide risk control. Bill Gross owns more than $1 million in shares of this fund. The fund employs a relatively low 21% leverage and has an expense ratio of 1.5%.
- PIMCO High Income Fund (PHK). This fund is well known for its high premium and sells for a tremendous 49.5% above net asset value , which is slightly higher than its average 43% premium. The distribution is an extremely high 12.4%, which has been achieved with only a small (less than 10% of the distribution) amount of ROC. The portfolio consists of 338 holdings, distributed among floating rate loans, asset backed bonds, corporate bonds, and Government bonds. About 10% of the holdings are domiciled outside the USA (mostly Brazil) and about half are investment grade. Bill Gross took over the management of this fund in 2009 and it has been one of the top performers in terms of total return. The fund utilizes 21% leverage and has an expense ratio of 1.1%.
The following funds are managed by Dan Ivascyn, who joined PIMCO in 1998 and is a managing director of the firm.
- PIMCO Income D (PONDX). This is a go anywhere mutual fund and has its portfolio spread over many sectors including mortgage backed securities, non-US developed markets, emerging markets, and Government bonds. About 15% of the portfolio is in non-US based securities. The effective duration is a short 3.7 years. Expenses are 0.75% and the yield is 6%. Note that there are other classes of this fund with different yields and expense ratios. In particular, PIMIX is the institutional class for this fund.
- PIMCO Income Opportunities (PKO). This CEF sells for a discount of 2%, which is well below the average premium of 3.6%. The distribution is a relatively high 8.4%, which has been achieved without any return of capital. This fund has 474 holdings that are divided among four primary asset classes: mortgage backed, investment grade corporate, high yield, and Government bonds. This fund utilizes a high 36% leverage and also has a high 2.3% expense ratio.
- PIMCO Dynamic Income Fund (PDI). This fund was not launched until May, 2012 so it does not have sufficient history to be included in my analysis. I mention it because it currently sells for a discount of over 9% (compared with an average discount of 2%) which is unusual for PIMCO funds. The distribution is 7.6%, which is achieved without ROC. The portfolio is mainly asset backed bonds. The fund uses a large amount of leverage (47%) and has a very high 2.9% expense ratio.
To analyze risks and returns, I used the Smartfolio 3 program (smartfolio.com) over the past 5 years. The results are shown in Figure 1, which plots the rate of return in excess of the risk free rate of return (called Excess Mu on the charts) against the historical volatility.
Figure 1. Risk versus reward over past 5 years
As is evident from the figure, the PIMCO mutual funds are significantly less volatile than the CEFs. However, generally the CEFs have higher absolute returns. Were the returns associated with the CEFs commensurate with the increased risk? To answer this question, I calculated the Sharpe Ratio.
The Sharpe Ratio is a metric developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with PIMCO's Total Return fund PTTDX. If an asset is above the line, it has a higher Sharpe Ratio than PTTDX. Conversely, if an asset is below the line, the reward-to-risk is worse than PTTDX.
Some interesting observations are apparent from Figure 1. Even though the mutual funds have a lower absolute return, they have a much better risk-adjusted return than the CEFs over the past 5 years. PONDX had a slightly better Sharpe Ratio than PTTDX since it had a higher return and about the same volatility. Of the CEFs, PKO had the best risk-adjusted return and PFN the worse. PHK had an excellent total return but achieved this by taking excessive risk.
The correlation matrix associated with these funds is shown in Figure 2. As you might expect, PTTDX was moderately correlated (82%) with PONDX but for the most part, the CEFs were relatively uncorrelated with the mutual funds. This means that the CEFs would provide diversification to a mutual fund portfolio. Somewhat surprising, the CEFs were only moderately correlated with each other (correlations between 50% and 80%).
Figure 2. Correlation matrix over past 5 years
I next looked at the past 3 year period to see if the performance had changed. The results are shown in Figure 3.
Figure 3. Risk versus reward over past 3 years
As you might expect, the volatilities during the past 3 years were much smaller than those over the 5 year period, since the 3 year look-back period did not include the volatile 2008 and 2009 years. The volatilities associated with the CEFs were still much higher than the volatilities associated with the mutual funds. Over this period, PONDX was the best performer on a risk adjusted basis, handily beating PTTDX. Of the CEFs, PKO was still at the head of the pack. Generally, the other CEFs were relatively close to the "red line", indicating that their risk-adjusted performance was similar to PTTDX.
The investment landscape became even murkier in the more recent past. Since early this year, the fear of rising rates has taken its toll on many investments, including PIMCO funds. To get a more near term view, I ran the analysis from the beginning of 2012 to the present, a little over 1.5 years. This data is presented in Figure 4.
Figure 4. Risk versus reward since January 2012
The last 1.5 years have not been kind to PTTDX, with most of the CEFs performing as good as or better than this high profile fund. In contrast, PONDX had excellent results and is still leading the pack in terms of Sharpe Ratio. PKO maintained its high performance but lost its leadership position to PFL and PFN. However, on a relative basis, all these funds performed relatively well in an environment where treasuries were being plummeted.
Ivascyn's mutual fund (PONDX) was clearly the winner on a risk adjusted basis over all the time periods and his closed end fund, PKO, also had outstanding performance. Based on this limited sample, Ivascyn's funds provided better risk-adjusted returns than the funds managed by Bill Gross. However, it should be noted that all the PIMCO funds did reasonably well and a retiree interested in income should give these funds serious consideration.