Accessing Pimco's Alpha Via ETFs
After launching the actively managed Pimco Total Return ETF (BOND | B)—an ETF version of Pimco’s flagship Total Return Fund (PTTRX)—in February 2012, Pimco is looking to strike it big again in ETFs. BOND was the second-most-successful ETF launch in the 21-year history of ETFs, gathering its first $1 billion in less than three months.
Pimco in a recent regulatory filing has detailed a similar approach as it took with BOND, replicating three existing mutual funds in tradable ETF wrappers.
I’ll talk about one of those three proposed ETFs, partly because—like BOND—Gross will manage the new ETF version of the sister mutual fund he already manages, but also because the fund’s strategy is designed to outperform—and has outperformed—the S'P 500 Index in the past five years.
Accessing Pimco’s Brain Trust
Gross, giving investors a new way to access his star power, will manage the proposed Pimco Fundamental IndexPlus AR Active ETF (USFI), just as he already manages the related mutual fund, the $4 billion Pimco Fundamental IndexPlus AR Fund (PXTIX).
By the way, in case you missed it, the word “Fundamental” in the fund’s name refers to the fundamental indexing methodology developed by Rob Arnott, founder of Research Affiliates and the RAFI series of “fundamental” indexes.
While the RAFI index is worthy of a separate blog, today I’ll look at the role of Gross, his brain trust and focus on what Pimco does best—generating alpha for investors through active bond management.
The ETF will trade under the symbol “USFI,” and as I said above, it aims to outperform the S'P 500 Index, as does the mutual fund.
The ETF will cost 86 basis points, or $86 for each $10,000 invested, while the no-load institutional version comes in at 79 basis points. The ETF will disclose portfolio holdings daily, while the mutual fund adheres to quarterly disclosure frequency.
Swaps For Efficiency
The strategy of the proposed fund is what I consider to be Pimco-alpha overlay—bringing together the RAFI index’s “enhanced” beta with alpha through Pimco’s fixed-income active management.
This is how USFI would work:The fund would get 100 percent notional long exposure to the Enhanced RAFI 1000 Index via total return swap agreements. Getting equity exposure through swap agreements—including financing cost—requires a fraction of capital commitment compared with physically holding all underlying securities.
The use of derivatives frees up capital. The fund, through an active approach managed by Gross, will invest in a variety of fixed-income instruments, aiming to exceed the financing costs and outperform return from money market.
Indeed, the fixed-income part of the portfolio has a very long leash. It can use a wide range of fixed-income instruments including swaps, options and forwards to achieve a duration target between -3 and +8 years.
Adding them up, Mr. Gross and his team can precisely implement a variety of strategies in response to a range of different interest-rate outlooks. For example, the fund can short duration with Treasury futures while maintaining credit exposure through credit default swaps (CDSs).
Is There Any Alpha?
Let’s take a look at the existing mutual fund counterpart, PXTIX, for some insights. PXTIX and USFI share the same objective and strategy. While there’s no guarantee USFI will produce the same performance as PXTIX, analyzing PXTIX is a good proxy.
Pimco Vs. SPY Annualized Total Return (As of 7/31/2014) | ||||
YTD | 1 Year | 3 Years | 5 Years | |
PXTIX | 6.57% | 17.47% | 21.67% | 25.56% |
SPY | 5.57% | 16.77% | 16.69% | 16.66% |
Source:Bloomberg
The table above indicates that PXTIX has outperformed the S'P 500 Index by quite a margin in multiyear horizons. In addition to simple period return, I also ran a simple regression with daily returns. Regressing PXTIX on SPY, I found statistically significant annualized alpha in both the three- and five-year periods.
As of 7/31/2014 | Alpha | Beta | P-value | R 2 |
1 Year | 0.93% | 0.99 | 0.724 | 0.94 |
3 Year | 5.00% | 0.96 | 0.012 | 0.96 |
5 Year | 8.05% | 1.00 | 0.000 | 0.95 |
Source:Bloomberg
Gross’ Alpha
I decomposed PXTIX’s daily return into equity and the fixed-income returns by subtracting fund’s total return by the RAFI-index component of the fund’s total return. This method is far from precise, but gets me within the ballpark.
The difference between PXTIX and RAFI index return is the outperformance (or underperformance) that came from fixed-income exposure. A simple regression shows that Bill Gross has been consistently bringing additional returns; in fact, on average, 3 basis points of additional returns (~7.44% annualized) on top of the RAFI equity index every day. This is simply impressive!
This fund and its return profile are exactly what I would expect from Pimco—generating alpha through active fixed-income management.
That said, here’s a final word of caution:
However impressive the return or the alpha may be, investors should be comfortable with the risk they’re taking. The proposed fund and its existing mutual counterpart provide leveraged exposures—a single sum of capital allows you to get 100 percent notional long equity exposure and actively managed fixed-income exposure.
As smart as Pimco’s brain trust is, there’s no guarantee it will always generate alpha. Combining with implicit leverage, the funds can potentially get hit from both sides if the markets turn against it. As such, in my humble opinion, USFI might not be a suitable core equity exposure in a conservative portfolio. It’s more suitable as a complement to the core equity exposure.
At the time this article was written, the author held no positions in the security mentioned. Contact Howard Lee at hlee@etf.com .
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