Performance-Chasing Bond Fund Money Starting to Flee

Dec.13.10 | About: iShares Core (AGG)

As I have pointed out, much of the massive retail flows into bond funds likely doesn't reflect as much of a search for "safety" vs. stocks as simply chasing the asset class with the most recent out-performance. Therefore, given that the bond market has reversed, it doesn't surprise me to see the following news in Barrons.

Since the Pimco Total Return is by far the largest bond mutual fund (and often shockingly the only bond fund choice in some 401k plans I have seen), the outflow from the fund is likely indicative of a larger trend among bond funds.

From the Barrons article

Pimco Total Return Fund Slips in Past Month; Investors Pull Money

Posted by Murray Coleman - The Bill Gross-led Pimco Total Return Fund (PTTRX) faced $1.9 billion in redemptions during November - its first month of net outflows in two years, according to Morningstar.

Another aspect of the large exodus from this fund is another issue I have raised before. As a "go anywhere fund," investors have no idea how the portfolio is allocated as to credit quality, bond category, duration and even nationality of the bonds held in the portfolio, The investment in this fund is less an investment in an asset class and more a bet that manager Bill Gross would continue his market-beating record. It was inevitable that the fund would stumble and inevitable that hot money would flee the fund once that happened, the fund is down around 6% mtd, underperforming the index (see three month chart vs. the the total bond market ETF (NYSEARCA:AGG).

Click to enlarge

Lately, it is underperforming the other large active fund. More from Barrons:

A separate report by Bloomberg comparing return data over the past 30 days, through Dec. 8, found that PTTRX lost more than all but one of the 10 largest bond mutual funds. The only top 10 bond fund that did worse was the Vanguard Inflation-Protected Securities Fund (VIPSX).

The reason behind the decline may be because Pimco has revised its much publicized forecast of the "new normal" with lower returns and slow growth. It seems plausible based on this view they would have been positioned on the long end of the yield curve. The fact that its performance underperformed the indices in a month when the long bond sold off sharply is additional evidence leading to that conclusion.

As for the forecast, the never shy Mohammed el Erian of Pimco is back in the media with what I guess is his "new, new normal:"

Equities climbed on Dec. 9 when Mohamed El-Erian, the chief executive officer and co-chief investment officer of Pimco, raised his forecast for next year’s U.S. growth as policy makers spend up to $600 billion to buy Treasuries through so-called quantitative easing. Pimco said the economy may grow 3.5% in the fourth quarter of 2011 from the year-earlier period, up from 2.5%.

Pimco, manager of the world’s biggest bond fund, said since May 2009 that gains in financial assets would be below historical averages for years to come. Bill Gross, the other co-chief investment officer, said on Dec. 3 that a Labor Department report showing hiring trailing forecasts in November shows gross domestic product isn’t expanding fast enough to sustain market rallies.

“The old normal was 6 to 7%,” Gross said in a Dec. 3 radio interview on “Bloomberg Surveillance” with Tom Keene. “The new normal is a 3% plus or minus nominal GDP. It speaks to 2% growth and 1% inflation. We are running at a half-size-paper-airplane type of economy as opposed to one with stable wings and full thrusting jet engines.”

That bond funds in general and PTTRX specifically should see such large outflows after one bad month indicates that further declines in bonds will lead to more outflows which could lead to further bond declines, which in turn could cause more outfolows triggering a negative circle.

The question is where the money will go. My feeling is that historical patterns will continue and the money will flow into stocks with investors chasing the outperforming categories: Emerging markets, small caps and commodity related companies as well as commodities themselves.

Two tendencies that tend to occur at year-end and the beginning of the New Year are likely to push these classes higher:

1.The practice of window dresssing by money managers who want to show they hold little cash and own the top performers.

2. The retail readjustments that often occur at the beginning of the year when investors put new IRA contributions to work and readjust their allocations.

This should lead to some momentum through the beginning of the year ... after that who knows. My inclination would not to be to add to these asset classes to ride the momentum but rather to rebalance holdings of these asset classes sometime early in the year to capture that rebalancing premium. Year end is probably not the best time to do the rebalancing. As this article points out, the argument for tax harvesting before year-end in some cases is not as persuasive as generally thought.

Disclosure: None