By Timothy Strauts
When PIMCO first announced the launch of an exchange-traded fund version of the largest U.S. mutual fund, PIMCO Total Return Instl (PTTRX), the general consensus was that it would be a successful ETF. Today, a little more than two months since its launch, PIMCO Total Return ETF (NYSEARCA:BOND) has thus far surpassed almost everyone's expectations. It is the fastest-growing active ETF ever, with more than $700 million in assets. BOND has not had the liquidity issues that some new ETFs have when they are brand new. It has a high average trading volume of more than 200,000 shares per day and bid/ask spreads of two cents or less most of the time. To top it off, the ETF was launched right as the Total Return strategy was outperforming the market. Since BOND's Feb. 29, 2012, inception, it is the best-performing intermediate-term bond fund in the Morningstar database by a substantial margin.
For an introduction to the differences between the ETF and the mutual fund, please read my earlier article on the topic.
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Source: Morningstar Analysts
Now that there is an ETF version of the popular PIMCO mutual fund, how do the two funds compare? Both have done really well. From BOND's inception until last Friday, PTTRX has returned 1.84%, which is good enough for the eighth-best performance in the entire intermediate-term bond category. In comparison, BOND has returned an astounding 4.1% over this period, besting the mutual fund by 2.26%. This is an incredibly large return difference for two funds that follow the same investment strategy.
With a little over two months of return data, we now have barely enough data to perform some basic statistical analysis on the two portfolios. I will caution that these results will definitely change over time and should be taken with a grain of salt because of the very short time period tested. For these calculations, the Barclays U.S. Aggregate Bond index is the benchmark. I’ll review each measure and discuss the results.
Source: Morningstar Analysts
Alpha is an annualized measure of outperformance of an active manager versus a benchmark. You can see that both funds have had strong alpha, but these very high numbers show one of the downsides to using short time periods because outperformance gets exaggerated when looked at with annualized statistics. It is safe to assume that going forward, it will be impossible for BOND to outperform by 18% over a full year. Anyone anticipating this outperformance will likely be sorely disappointed. While unsustainable, the recent returns are still impressive for both funds.
Beta is a measure of the volatility of a fund in relation to its benchmark. The benchmark has a beta of one, so a number higher than one indicates higher volatility and conversely, a number less than one indicates lower volatility than the benchmark. Both funds have volatility very similar to the benchmark, but PTTRX has had a little higher risk. It will be interesting to see going forward if BOND continues to have lower risk in the months ahead.
Correlation is a measure of how the fund moves in relation to its benchmark. Correlation differs from beta in that it describes only whether two things move in the same direction and not the magnitude of the move. For this measure, the ETF and the mutual fund are very similar and clearly both hold securities that are highly correlated to the index.
Average return in up/down days shows how the funds react when the index is up and how things change when the index is down. One can see that on down days, both funds have lost less than the index, and on up days both funds have gained more than the index. This is exactly want investors should want from an actively managed fund. BOND performs slightly better than the mutual fund, with its biggest advantage being that on the down days it has lost less than half as much as the index.
What Is Different?
From looking at the statistical measures, the ETF and mutual fund clearly are very different portfolios. There are two main reasons why the ETF has outperformed by so much. The funds have differences in the types of securities they can buy and are at the opposite ends of the spectrum in regard to the number of portfolio holdings.
BOND is restricted from using derivatives in its portfolio. The ETF must own individual bonds to get exposure to the market. By contrast, the mutual fund can get various bond exposures through swap agreements. The benefit of individual bonds is that PIMCO can employ its sector specialists to pick out the best possible bond issues. Getting bond exposure through a swap agreement limits one's ability to pick out individual credits because the swap often is based on a broader index. If a manager is managing a large portfolio, making large asset-allocation changes can be an expensive undertaking that risks upsetting the market. Swap agreements allow PIMCO to stay nimble with its very large portfolio. More complex portfolio hedging strategies using options or credit default swaps will also be unavailable to the ETF. These hedging transactions can be very beneficial if the market becomes more volatile, but when the market is functioning normally these securities are added costs to the mutual fund.
When BOND was launched with about $100 million in assets, Bill Gross was able to start fresh with a brand new portfolio that had no legacy positions. The recent outperformance shows how a highly skilled active manager can add tremendous value in a small portfolio. It pays to be little. PTTRX has more than 19,000 holdings, whereas BOND has just over 300. Because the ETF portfolio is very nimble, PIMCO's best individual bond ideas can be bought with large percentage allocations. Effectively, the ETF is performing like Bill Gross's "best ideas" list. In the mutual fund, if a PIMCO credit analyst finds a mispriced corporate bond, adding it to the large portfolio will have minimal effect on the portfolio's returns. Add that same bond to the ETF and it could make a big difference in the returns. The ETF also can make quick changes to its allocation without unsettling the market. For example, if PIMCO wanted to reduce its allocation to emerging-markets bonds in the mutual fund from 10% to 2%, it would need to sell $20 billion of emerging-markets bonds. That's not impossible, but it's very hard to execute quickly. In the ETF, that same change would involve selling only $56 million in securities.
Active ETF Landscape
Many people have doubted whether active ETFs would ever take off in the market. The active ETF space is quite small, with only $6 billion in assets in 48 ETFs. With its phenomenal growth, BOND currently is the third-largest active ETF and will likely be the largest active ETF by the end of the year, if current asset growth continues. This success is likely to encourage others to launch new active products in the fixed-income space. I wouldn't be surprised if PIMCO continues leading the charge and launches an ETF version of PIMCO Real Return Instl (PRRIX) or any of its other successful fixed-income mutual funds. The key to success will be following PIMCO's road map of launching an established strategy with above-average historical returns at a competitive expense ratio.
Which One is Best
After looking at the recent performance numbers there is a natural inclination to think that BOND is the best place for your money if you're interested in the Total Return strategy. However, I would caution investors against making large asset-allocation decisions off of just two months of returns. Be patient. Things can change quickly in the bond market, and the mutual fund's superior hedging capabilities could make a big difference in the months ahead. If your portfolio has an allocation to the mutual fund, I would recommend sticking with the mutual fund for now, as long as it's invested in the low-cost Institutional or P share class or Harbor Bond (HABDX). That being said, the ETF does offer the unique opportunity to get the management expertise of the one of the best active managers ever in a portfolio where his insights can be implemented quickly.