Is The PIMCO Total Return ETF The Right Bond Fund For You?

| About: PIMCO Total (BOND)
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Summary

The PIMCO Total Return ETF is technically a bond fund but uses active management, which includes short positions.

The allocations in the portfolio have created higher yields for the fund.

Higher expense ratios are generally a negative factor, but this portfolio is more intricately positioned than most.

Interest rate policy from central banks is diverging, which creates opportunities for talented managers.

The PIMCO Total Return ETF (NYSEARCA:BOND) is a very interesting bond ETF that many investors may not know about. Assets under management are only $2.6 billion but the fund pays a monthly dividend and uses a very complex portfolio to seek yields through an interesting combination of positions. This is not even remotely close to your standard bond fund.

Expenses

The net expense ratio for BOND is .55%. Normally I would suggest that an expense ratio in excess of .50% was absurdly high and that it would be very difficult for the bond fund to establish superior performance in assets by a large enough margin to pay for the expense ratio while still delivering full risk adjusted returns to the shareholders. This is one time where I won't say that because the portfolio here is far more complex than simply reallocating to follow an index of liquid securities.

Yield

The website for PIMCO, the fund sponsor, listed the distribution yield at only 2.15%. The distributions may be a bit challenging for bond investors because the fund's dividends have varied quite substantially:

Duration

The following chart demonstrates the sector exposure for this bond fund:

The outer ring in the chart shows the construction of the index while the inner ring demonstrates the exposures of the ETF. Investors may recognize that the fund is holding dramatically more of the middle duration securities (3 to 5 years) than the index and substantially less of the shorter duration securities. They are also going light on the 5 to 10 year range. It might seem like the ETF is deviating slightly from their index, but as I dug deeper the difference between the ETF and the index only grew wider.

Sectors

The following chart demonstrates the sector exposure for this bond fund:

You may notice at even a glance that the fund holds substantial negative positions in two of the sectors while the index has zero negative positions. This is a clear cut case of active management in the fund and this may be one of the better opportunities for it. By shorting some other positions the fund is able to more effectively express the viewpoints of the fund managers.

The Strategy

The fund was choosing to remain underweight on domestic sources of duration (such as longer treasury bonds) based on expectations for the Federal Reserve to raise rates and to create losses for investors holding significant portfolios of treasury assets. On the other hand they positioned the portfolio to benefit from a strengthening of the U.S. dollar relative to the euro, the yen, and a basket of emerging market currencies in expectation that the central bank policies around the world would move in different directions. That expectation looks solid as the Federal Reserve continues to call for increases in domestic rates while the ECB (European Central Bank) went even further into negative interest rates to provide stimulation for the economy in Europe.

From the monthly commentary:

We continue to be opportunistic in corporate credit, looking to selectively invest in companies that are benefiting from increased pricing power and industry consolidation. We continue to hold intermediate TIPS as we believe policymakers will ultimately be successful in raising inflation expectations. We believe non-Agency MBS remain attractive given supply constraints and the housing market recovery and continue to seek relative value opportunities in Agency MBS.

My Thoughts on the Commentary

The strategy seems reasonable in regards to selecting corporate debt that will benefit from increased pricing power and industry consolidation. The fund simply needs to be better at doing this than other investors aiming for the same general strategy. By locating the right companies that will be benefiting from superior pricing power the company would (at least theoretically) have the opportunity to buy higher credit quality debt at the prices (and yields) of lower credit quality debt.

Active Management

Given the divergence in central bank policies this may be a more effective time for active management to take advantage of failures in market pricing. There have been a few opportunities lately, including the negative interest rate policies in Europe, where we have learned that the old economic textbooks were wrong. It was previously believed that negative interest rates would be impossible since investors could simply hold cash. Due to the costs of holding and insuring cash, it turns out that simply holding cash is not free.

The Federal Reserve is aiming to increase short-term rates despite barely reaching full employment and inflation running 0%. If inflation isn't 0%, someone should really explain it to the SSA (social security administration) since they declared no change in the price index and therefore no increase in payments to retirees. The Federal Reserve has a target interest rate of 2%. Economic theory suggests that since inflation is officially 0% and the goal is 2%, rates should remain low until inflation picks up. Since the Federal Reserve is pursuing options that don't fit the dual mandate, it looks like talented management may be able to earn their expense ratios by taking advantage of the opportunities that are created by different policies in each country.

Overall Outlook

I normally dislike funds with higher expense ratios, but I appreciate the way this portfolio is being managed. This level of research into the different opportunities for yield is pretty impressive. Overall, I have to say those two things are pretty much balancing each other out. On the other hand, I see the market being valued at exceptionally high levels and what appears to be a fairly weak yield advantage for weaker credit securities. Consequently, I would be scared to wade into any junk bond ETF or mutual fund at this point.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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