Bill Gross just released a letter in which he apologized to investors for the poor performance of Pimco Total Return. For the year, Pimco has underperformed its index, the BarCap Aggregate Bond, by more than four percentage points.
For a top-performing fund like Pimco Total Return, this kind of underperformance is very unusual. The type of public apology Gross has issued is also very unusual and laudatory. However, in my view, the tone of the letter is overly apologetic given how well the fund has done over a long period. In any case, here is an excerpt [emphasis added]:
…The simple fact is that the portfolio at midyear was positioned for what we call a “New Normal” developed world economy – 2% real growth and 2% inflation. When growth estimates quickly changed it was obvious that I had misjudged the fly ball: E-CF or for non- baseball aficionados – error centerfield.
So where do we go from here? Our internal growth forecast for developed economies is now 0% over the coming several quarters and the portfolio more accurately reflects this posture….
0% growth ahead!
What went wrong with Total Return this year and what are they doing about it? Read on.
Earlier this year, Bill Gross, Mohamed El-Erian and the rest of the Pimco brain trust thought we would see modest economic growth in the range of 2% after inflation growth. They shortened the duration (weighted average maturity) of the portfolio and moved away from Treasury bonds.
Now, their view has changed dramatically. In fact, they foresee very weak economic growth — zero percent growth in fact – in the U.S. and other developed countries. As a result, they are extending the duration of Pimco Total Return (PTTRX). This is quite a change from earlier this year.
Mohamed El-Erian: Between concerned and scared
The impetus for these changes is a very weak economic outlook as expressed in this blog post from Pimco’s CEO Mohamed El-Erian [emphasis added]:
…At an event last week in Washington, I was asked about my feelings about the global economy. My response was “between concerned and scared.” …We are here because of the interactions of three distinct, yet inter-related forces: poor economic growth, excessive contractual liabilities, and disappointing policy responses. The result is that western economies are getting trapped by the lethal combination of an unemployment crisis, a debt crisis, and mounting fragilities in the banking sector.
The longer this persists, the greater the risk that even the healthiest parts of the global economy, and thankfully there are still quite a few, will get dragged into a prolonged period of economic and financial stagnation…
Earlier this year, Bill Gross thought higher interest rates were coming so he positioned the portfolio accordingly. Higher rates did not happen and, as all good portfolio managers do, he determined that his outlook was incorrect and he changed course. Here are two ways in which Pimco Total Return is changing its portfolio:
Going long & going overseas
Going long: The fund has gone about as long as it can go. In six months, it has increased the portfolio duration from 3.6 years to its current level of 7.14 years. Kevin Winters of Pimco gave me some clarification about the fund’s duration policy. The fund compares its duration to that of a bond index, the BarCap Aggregate Bond Index. Essentially, Pimco Total Return’s duration can be as much as two years less than the duration of the index. Or, it can be up to two years longer than the index duration. Right now, the fund is about two years over the index duration so Pimco is at the upper end of its policy range.
Going overseas: Another portfolio change is that the fund is moving more assets into securities from non-U.S. countries. The portfolio percentage in these types of securities is now 21% in bonds from developed countries alone plus a smaller amount in bonds from emerging markets. The foreign holdings include positions in securities from Canada, Great Britain and Mexico.
With these changes, Pimco is clearly taking a stand that economic activity across the globe is weakening and that interest rates will be soft. If Pimco’s view is correct, and I think it is, this bodes well for bonds, but not for the economy as a whole.
Here is a link to Pimco Total Return’s portfolio statistics through September 30, 2011.
Hat tip for Mea Culpa letter: Dealbreaker
Hat tip: Kevin Winters and Cort Escherich at Pimco
Disclosure: Kurt Brouwer owns shares in Pimco Total Return (MUTF:PTTRX)