But Gross should also be recognized for another feat: operating stock funds that have surpassed the S&P 500. During the past five years, his PIMCO Fundamental IndexPLUS
Other winners include PIMCO StocksPLUS Absolute Return
Gross has shined in stocks by relying on a complicated strategy that employs his bond trading skills. While most equity managers hold shares of stocks, Gross uses a mixture of bonds and futures as well as other derivatives. Futures enable a trader to buy something at a fixed price in the future.
To appreciate how Gross works his magic, consider an investor who has $10,000 and wants to take possession of stock worth that amount three months from now. To accomplish the goal, he purchases futures. The value of those rises and falls along with the stock price. The trader may need to give a broker only $1,000 in order to control the full $10,000 worth of the stock. This ability to leverage explains why futures are popular.
After buying the futures, the trader can put the rest of his cash in money-market funds or other investments. Say the stock rises by $1,000. The value of the trader's futures will rise by that amount -- plus he will record any profits produced by the cash holding.
For PIMCO StocksPLUS, Gross buys futures that track the S&P 500 and puts his excess cash in a bond portfolio. If the fixed-income holdings earn nothing, the PIMCO fund will trail the stock benchmark by whatever it costs to trade the futures.
The cost of employing a futures contract rises and falls with money-market rates. At the moment, the futures cost about 0.30%. If the PIMCO fixed-income holdings return more than the futures cost, then the fund will outperform the S&P 500.
You might think that any bond manager should be able to top money-market rates. In fact, the strategy is extremely difficult to execute. Gross comes up short some years, and competitors have done worse.
Since the financial crisis, PIMCO StocksPLUS has generally topped the benchmarks. In 2012, the fund returned 21.1%, outperforming the S&P 500 by 5 percentage points and surpassing 96% of large blend funds.
Gross scored gains by emphasizing corporate bonds and lower-quality mortgages. Those outperformed money markets by a wide margin. The fund trailed the benchmark for a three-year period starting in 2004. During those years, maintaining futures positions cost around 5%, and it was relatively hard for bond managers to compensate for the steep expenses.
If interest rates rise in coming years, as many economists expect, then the PIMCO funds could face harder times. When rates climb, bond prices tend to fall. But Gross has enough tools to continue topping his benchmarks.
PIMCO StocksPLUS Absolute Return is allowed to sell bonds short, profiting from falls in prices. PIMCO StocksPLUS is not permitted to short. But it has the freedom to buy high-yield bonds and other issues that sometimes rise during times of climbing interest rates.
PIMCO Fundamental IndexPLUS ranks as one of the company's most notable funds. While most of the PIMCO IndexPLUS funds seek to outdo common benchmarks such as the S&P 500, the fundamental fund aims to top the Enhanced RAFI 1000 index. Designed by Research Affiliates, the RAFI benchmark weighs stocks according to fundamental measures such as sales and dividends.
Under the RAFI system, companies with large sales have a bigger impact on the benchmark. That is very different from standard benchmarks, which weight stocks according to their market values. Apple
Proponents of fundamental benchmarks say that their system is superior because it avoids giving great weight to the hottest stocks. Lately the fundamental approach has been outperforming. That has helped PIMCO Fundamental IndexPLUS to top the S&P 500. The RAFI approach has also excelled overseas. During the past three years, PIMCO Emerging Markets Fundamental IndexPLUS
At the time of publication the author had no position in any of the stocks mentioned.
This article was written by an independent contributor, separate from TheStreet's regular news coverage.
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