About Those Actively Managed Bond Funds

In an earlier post I wrote that using an actively managed bond fund is particularly poor choice for the income allocation in a portfolio since it does not fulfill the function of a bond allocation in a portfolio. This is particularly true of “go anywhere” bond funds which have not limitations on the maturity or type of bond that they own.

The fixed income portion of a portfolio is supposed to reduce the overall risk of a portfolio by adding to the asset mix a bond position that provides fixed interest payments and return of principal, as close to a riskless asset as possible. As many others have pointed out the way to do this is to limit the risk due to interest rate fluctuations by keeping the maturity short and to minimize the risk of default by purchasing only government or very high quality corporate bonds. For most individuals this means a very low cost bond fund or etf indexed to a high quality short term bond index. Two good choices would be the ishares Lehman Brothers 1 -3 treasury bond index etf or the ishares Lehman 1 -3 Government – Credt bond index etf. Vanguard offers mutual funds that target the same indices and an etf that targets the govt credit bond index.

On the other hand the actively managed fund particularly a “go anywhere” fund is simply giving your money to a manager who takes bets on the future course of interest rates and the relative performance of various sectors of the market. In fact he the managers of these funds do the exact opposite of the strategy described in the above paragraph. It wanders all across the fixed income markets. Based on its forecast for the direction of domestic and international interest rates, credit spreads, currencies and other factors they compose a portfolio. There is no guarantee the returns will be stable and no transparency as to the content of the portfolio, it will change based on the judgements of the manager about the bond market.

Do you really want a portfolio including Brazilian government bonds denominated in foreign currency and not currency hedged as part of the portion of your portfolio allocation that is supposed to be stable and very low risk ? I think not.

So when I read this article in the WSJd I wasn’t particularly surprised

Pimco's Gross:
Living Down
A 'Big Mistake'

Wrong Bet on Rates
Lands Big Bond Fund
Near Bottom of Pack

The article is abut PIMCO’s Bill Gross, considered one of the best bond managers in the world and his Pimco Total Return fund one of the largest bond funds in the world and yes a “go anywhere “ fund

The “news” in the article is that even a bond guru like Gross can make bad market calls and when he invests the funds money according to those market expectations the fund returns and the shareholders suf fortunately, Mr. Gross is having to accompany both occasions with a mea culpa.

Last year, Mr. Gross, chief investment officer at Pacific Investment Management Co., became convinced that the U.S. housing market was in dire shape, and that the Federal Reserve would have to cut interest rates as a result. So he stocked up on securities that would gain from a rate cut. And he avoided high-yielding corporate bonds, on the assumption that a slowing economy would hurt riskier debt.

That call, Mr. Gross acknowledges, was a "big mistake."

While he was right about the housing market, he was wrong where it counts -- on interest rates. The Fed hasn't cut rates, and high-yield bonds have been on a hot streak.

As a result, the $104 billion Total Return Fund is trailing far behind the competition for the past year. In the past 12 months, the fund is up 6.22%, compared with an average 6.96% for similar funds. That may not seem like a lot, but in the world of bonds, a few hundredths of a percent make a big difference. Today, the Total Return is trailing roughly three-quarters of its peers.

This is a rare extended spell of bad performance for Mr. Gross. In the past 10 years, Total Return Fund has provided investors with better returns than 97% of the competition. Until last year, it had never once landed in the bottom half of its category for a calendar year, according to fund-tracking firm Morningstar Inc.

Since Mr. Gross took the helm of the fund in May 1987, Total Return has posted an average annual return of 8.29%, compared with 7.25% for the average fund in Morningstar's intermediate-term bond-fund category. During this period, the average bond fund gained 6.55%, and the average stock fund gained 9.98%. Pimco is a unit of Germany's Allianz AG.

Despite the current woes, observers and clients say it would be a mistake to count Mr. Gross out. "Certainly, styles go in and out of favor...but Bill Gross is an example of a portfolio manager who's demonstrated through different market conditions that he's a great investor," says Michael Travaglini, executive director at the $48 billion Massachusetts state pension fund, which has $1.3 billion in the Total Return Fund.

As of last week it got even more interesting Pimco has hired ex Fed Governor Allan Greenspan as a consultant. The WSJ writes:

PIMCO's famed fixed-income manager Bill Gross will be getting a bit of help from former Federal Reserve Chairman Alan Greenspan. PIMCO just announced that it has retained Greenspan as a special consultant. He'll participate in the firm's quarterly cyclical Economic Forums, as well as its annual Secular Forum.

Far from being an academic exercise, these meetings help Gross and the entire investment management staff at PIMCO set interest-rate, sector, credit-quality, and country and currency positioning across their lineup of bond funds, including PIMCO Total Return PTTDX , the nation's largest bond offering. Greenspan's knowledge of the internal workings of the Federal Reserve.

Having Mr. Greenspan on board as an economic consultant fits into Mr. Gross's investment strategy. "A lot of mental energy is expended at Pimco trying to figure out what's going to happen with interest rates," says Paul Herbert, a fund analyst at Morningstar. That differs from some other bond managers, who place more emphasis on picking individual bonds or sectors of the bond market, and try to minimize the importance of getting the precise interest-rate calls correct, Mr. Herbert says.

Will the outome of the Greenspan input be significantly than Gross’ bad call described below ?:

Early last year, Mr. Gross's outlook for the U.S. bond market hinged on housing. "We did our homework," he says. "We sent out scouts into middle America, down to Florida." They did make some correct calls, such as predicting a drop in long-term interest rates last summer.

What Pimco didn't foresee was the impact on the U.S. of the strength in the global economy, led by China and the rest of the Asia. Mr. Gross says they recognized there was inherent strength abroad. But they counted on issues such as the U.S. trade deficit and increasing leverage around the world to have "snapback potential like a rubber band" that would restrain growth and allow the Fed to lower rates. That didn't happen.

Two interesting things emerge from the above paragraphs

1. The performance of the Pimco fund is particularly dependent on subjective forecasts of the economy and interest rates; something that is inherently fallible. In one description of Pimco’s economic research the WSJ reports that Pimco sent “scouts” that looked at the housing market in Florida and other locations . But their scouts they missed the obvious downturn. Pimco didn’t really need much in the way of” scouts” to learn about the state of the Florida real estate market. A phone call to my sister and her neighbors in south florida would have told them that the air was coming out of the Fla real estate bubble.
2. Alan Greenspan is a very bright man. But unless he is getting illegal inside information from his former colleagues at the Fed and sneak peaks at government economic data, it is unlikely that his input in Pimco’s decision making will have any impact on their investment returns.

I also wasn’t surprised to find an article entitled

Four of Our Favorite Core Bond Funds

Published on morningstar’s website on virtually the same day as the WSJ article on Pimco’s missteps. All four of the funds we were the type of “go anywhere funds” that are precisedly the wrong kind to hold as a core holding in the bond allocation of a portfolio. And which fund was one of the four: Pimco Total Return In their description of the fund Morningstar writes:

…. PIMCO is more convinced than the others that the Fed will have to lower rates, and relatively soon, to prevent a calamity in the property market. To capitalize from this eventual easing, they're taking on more interest-rate risk than peers are.

In other words, they are taking a big bet on the direction of interest rates.

But is it worth tying the returns on your fixed income allocations to bets based on the analysis of bond guru Gross and his adviser Uncle Alan. Wouldn’t you be better of with a simple short term bond index instrument, either the vanguard fund or ishares etf that index the short term govt/corporate index. Here are the numbers:

	1 yr	3yr	5yr
Vanguard Short term bond index	5.66	3.09	3.51
Pimco Total Return	5.75	3	3.5

The returns are basically identical and perhaps more importantly Morningstar’s own data find that the standard deviation of the funds , an often used measure of risk shows the pimco fund 75% riskier than the vanguard fund with a standard deviation of 2.84 vs 1.64.

And I wouldn’t think the odds for the pimco fund outperforming the index fund over the long term are particularly high; and even if it does it will do so by taking significantly more risk. The vanguard index fund has a management fee of .17%. By comparison the pimco fund has a management fee of .90% (some classes of the fund even have front or back end loads)

A .70% management fee differential is huge even though at first glance it may not look like much. Assume the long term return on a bond fund will be in the area of 5 -6% per annum .That means the extra fees on the pimco fund chops off over 10% of the funds returns. Put another way Bond Guru Gross has to do 10% better than the fund on autopilot (index fund) just to stay even. Even with the help of Uncle Alan it won’t be easy at all.

Here are some numbers (from the pimco website) showing the risk the fund is taking to get the higher returns: mortgage back securities make up 42% of the portfolio, government/agency 29%, high yield (junk) corporate 3%, investment grade bonds 2% foreign developed bonds 12% and emerging market bonds 4% . By contrast the Vanguard fund is 95.5% domestic, 93% A rated or better(no junk bonds) and 70%govt /agency.

As is the case in stock investing, bond investors are far better off indexing than tying their fortunes to an actively managed fund. Even one run by the top “bond guru” and the man who was formerly the most powerful man in the world economy.