[This article will appear in the March 2012 edition of ETFR .]
It may be the biggest ETF launch since SPY.
In March, fixed-income management firm Pimco plans to launch an exchange-traded fund version of its flagship Total Return Mutual Fund (PTTRX). The ETF will be actively managed by Pimco founder and PTTRX leader Bill Gross, often hailed as the best mutual fund manager in the world. If successful, the ETF could change how active funds are perceived in ETFs.
But though the two funds share a name, they’re not identical. In fact, the differences between the mutual and exchange-traded funds could mean a significant difference in return, particularly over any specific time period.
There’s a lot to be excited about for the Pimco Total Return ETF (ticker:ticker::TRXT). Take intraday trading. While PTTRX can only be traded once per day—after the close—TRXT, like all ETFs, will trade throughout the day, just like a stock. Given the likely popularity of the new ETF, we expect real liquidity to develop in the fund, keeping spreads tight. And like any stock, TRXT’s tradability will lead to a number of ancillary benefits (marginability, etc.).
Cost, however, is the biggie:TRXT is set to have an annual expense ratio of 0.55 percent. That’s 30 basis points cheaper than the “A” class mutual fund version that’s most readily available for retail investors. The bulk of that cost savings is driven by the fact that TRXT will not charge 12b-1 fees, the much-despised fees mutual funds levy to cover sales and marketing costs.
Combined, these benefits will make the ETF a nice vehicle…
… if it delivers the returns people expect.
After all, the real key to TRXT’s appeal is simple:Bill Gross. Investors are excited about this fund because they hope that TRXT will replicate PTTRX’s tremendous performance (while retaining the added ETF benefits).
Launched in 1987, PTTRX eventually grew to become the largest—and arguably most successful—mutual fund in the world, with over $250 billion in assets under management and a five-year return of over 50 percent.
A large factor in that performance is the freedom Gross has in managing it. According to its prospectus, PTTRX devotes “at least 65 percent of its total assets” to fixed-income products, but may also invest up to 10 percent of assets in junk bonds and 30 percent in foreign-denominated products, including another 15 percent in products tied to developing nations. Those are all standard allocations for a bond fund seeking high returns, and a quick read of the prospectus would lead most investors to think that they’ve got PTTRX figured out.
But they’d be wrong. In fact, it’s extremely hard to tell how Gross runs the fund. The holdings list for Total Return is over 300 pages long, and because it’s only published quarterly, is long since out of date by the time a potential investor starts her homework.
Buried inside those 300 pages is one kind of holding that most mutual fund investors rarely think about:derivatives. According to the prospectus, Gross and his team can invest “without limitation” in derivatives for PTTRX, including options, futures or swaps. ETFR’s review of the holdings suggest that PTTRX uses derivatives primarily for two reasons:1) to adjust interest-rate exposure; and 2) to hedge against credit risk.
The utility of interest rate swaps is clear:They can be used to quickly adjust duration.
For example, say Total Return adds a large position in long-maturity Treasury bonds, hoping to lock in their attractive yields. The move may signal Gross’ confidence that the Federal Reserve won’t crank up interest rates. But if there are timing concerns, or short-term changes in the market, Gross can use interest-rate swaps to either raise or lower the fund’s total duration quickly. This constant dialing up and down gives PTTRX an extreme amount of flexibility.
The CDS side may be just as important. PTTRX often buys credit default swaps as insurance. That insurance is a double-edged sword, however:If the market does well, the cost and dilution of those CDSs should hurt the mutual fund’s performance. If the market falls apart, the swaps pay off. There are even indications that the fund has sold CDSs in the past—doing so would express a position that a borrower won’t default, without requiring the fund to actually hold the bond.
Realistically, there’s little limit to what Gross can use these derivatives to achieve.
What’s The Issue With The ETF?
All this is relevant because, as of this writing, the U.S. Securities and Exchange Commission has a lockdown on providing exemptive relief from the 1940 Act for new ETF issuers that want to use swaps or other derivatives inside portfolios. The fear is that these derivatives may be too risky for end-investors, and while the regulatory board decides whether or not to tighten current restrictions, no one gets to use them.
This pulls an effective tool out of TRXT’s belt. The fund’s full prospectus addresses this, stating that the ETF “will not invest in options contracts, futures contracts or swap agreements, in accordance with the Trust’s current SEC exemptive relief. Should the SEC modify the Trust’s current exemptive relief or otherwise issue guidance or relief such that the [ETF] may utilize one or more of these derivative instruments in reliance thereon, the [ETF] may revise this policy accordingly.”
Outside of that statement, the prospectuses for both the mutual fund and ETF are essentially identical. But it’s a significant limitation, and one that begs the question of how truly comparative the portfolios for these products will be.
Another potential concern of the ETF structure could be seen as an advantage for others:portfolio transparency. While PTTRX discloses its holdings quarterly, TRXT will have to—by law—disclose its full portfolio on a daily basis, raising the risk of other market participants front-running the portfolio. This is not insurmountable—Pimco’s Enhanced Short Maturity Strategy ETF (NYSE Arca:MINT) follows an active strategy with bonds, discloses its portfolio daily and has been a major success, attracting $1.4 billion in assets. But it does mean that investors will see Bill Gross’ magic on full display. In fact, some wonder if TRXT will follow different tactics than the mutual fund, to avoid the possibility of investors front-running the bigger portfolio.
Which One To Buy?
So should investors buy the mutual fund or the ETF? It’s not an easy question to answer.
It’s fair to expect that Gross and his team will make the ETF as identical to the mutual fund as possible—after all, they’ve taken the bold step of naming it the “Total Return ETF.” But we know an entire class of holdings—derivatives—will be absent until the SEC lifts its lockout. Determining how those derivatives, or the lack thereof, impact performance is like hitting a mosquito with a dart.
Dave Nadig, director of Research at IndexUniverse, believes TRXT’s lack of derivatives might lead to a more volatile ETF in the short term. “TRXT will have vastly fewer holdings and an inability to hedge out interest and tail risk,” he said. “That will make the ETF far more subject to spikes, because there will be no insurance.”
Not everyone agrees. Michael Paciotti, chief investment officer at Integrated Capital Management Inc., sees the lack of derivatives as lowering risk for the portfolio. “With the mutual fund, when you use derivatives, that brings leverage,” he said. “Pimco’s point of view is that, if a portfolio’s leverage doesn’t affect its duration, it’s not risk-based leverage.”
But Paciotti believes that the leverage still affects you in tail events, like the 2008 financial crisis. “I don’t think the leverage created by derivatives is meaningless, because in a liquidity event it will be meaningful.”
Without the derivatives, Paciotti said, Pimco may have to run the ETF the hard way. “In the mutual fund version, the fund is far too big to generate excess return through individual bond selection.” He believes the fund uses derivatives to tilt the portfolio toward different factors easily—doing so through actual bond trading would be like steering the Titanic.
Trading the bonds in a new ETF is possible, but there are downsides. “I don’t think investors would be happy with the results, because of transaction costs,” said Paciotti. “And their ability to move quickly in that type of portfolio would be greatly reduced, which would hurt their alpha.”
One thing everyone agrees on is that the ETF will not be exactly like the mutual fund. It will be cheaper and more liquid, but will have a different portfolio than the fund.
No matter the name on the label, investors will have to make a choice between the two products—and do their homework before they buy.Permalink | ' Copyright 2012 IndexUniverse LLC. All rights reserved
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