Opinion

Felix Salmon

Why Bill Gross’s mistake is excusable

By Felix Salmon
August 31, 2011

Commenter Stevensaysyes asks if I could reassess my take on Pimco’s Total Return Fund, given its underwhelming performance year-to-date. Always happy to take requests!

So, first, and most obviously, you’d have to be an idiot to exit the Total Return Fund on the basis of its performance over the past nine months. This is a long-term investment vehicle, and has still comfortably outperformed nearly all of its peers over any reasonably long-term time horizon. Everybody is human, even Bill Gross, and Gross is more than happy to fess up to his mistakes and learn from them.

But of course it’s also important to look at exactly what Gross’s mistake was, and whether it was stupid or reasonable. And the answer is that it probably falls in the “reasonable” category.

The big picture here is that the Total Return Fund does what it says on the tin: it’s a fixed-income fund which tries to maximize the total return to investors. Fixed-income instruments come with a certain yield; all else being equal, the higher the yield, the higher the return to investors. And as a rule, Treasury bonds have the lowest yield of any fixed-income instruments. As a result, then, you’d expect the Total Return Fund, in normal times, to own no Treasury bonds at all.

When bond investors turn bearish, they do a couple of things. One is to reduce duration: sell bonds with long maturities and buy bonds with shorter maturities, which are safer. And the other is to reduce credit risk: to sell riskier bonds which are more likely to default, and buy safer bonds which are less likely to default. The safest bonds of all, in this respect, are Treasuries, which is why Treasuries tend to rally when the rest of the market is falling or bearish.

Buying Treasuries, then, is not something you should do every time you think they’re going to rise in value. If there’s a broad-based environment of falling interest rates, with yields on corporate bonds falling at the same rate as yields on Treasuries, then you’re still better off in the higher-yielding corporate bonds than you are in Treasuries.

So the only time that you’re wrong to sell out of Treasuries is in advance of a time when rates fall even as spreads rise. Holding corporate bonds makes sense over the long term, but in the short term, if credit spreads are rising, that’s likely to mean that prices are going down and you would have been better off waiting to buy. And, according to a handy S&P research note from earlier this month, credit spreads have been rising for most of this year.

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This chart, in a nutshell, is why Gross’s decision was a bad one — he didn’t expect spreads to rise nearly as far or as fast as they did. And they did so in exactly the worst way possible for Gross — as Treasury yields were falling. Here’s what’s happened since the beginning of July:

6348390.gif

That’s the kind of environment you very much want to be long rates and short credit — the one environment where owning lots of Treasury bonds makes you look smart.

Over the long term, though, I’d rather my bond-fund manager erred on the side of credit rather than on the side of caution. Pimco is one of the few fixed-income investors which does a huge amount of credit research; it should take advantage of that, and buy bonds which are trading cheap compared to their probability of default. Yes, it should play the rates game too. But as a general rule, if I want to maximize my total return, I don’t want to be holding vast quantities of low-yielding Treasury bonds. Gross is guilty of bad timing here. But I don’t for a minute think that this is the beginning of the end of the legend of Bill Gross, bond-market guru. Especially since he’s managed to do the one thing asked of all fixed-income managers, which is preserve value. His fund might be up less than those of some of his peers. But it’s still up for the year. Which counts for something.

Comments
16 comments so far | RSS Comments RSS

But hang on here. Gross openly stated he thought that US credit was degrading and yields would increase to reflect that, hence his play. Well the opposite happened to yields for reasons forecast by a few individuals who have been right for a while now. If you’ve figured out I’m really stating the same thing you did, congratulations.

The question is whether Gross understood the economics and it is clear he did not. I think he needs to consider hiring a good macro guy to his inner circle, and hey that’s no knock against him if he understands what’s lacking.

Posted by jesse1 | Report as abusive
 

@jesse 1

Admitting his mistake and being willing to learn from it rather than doubling down is a strength of Gross’ that cannot be overstated. Tens of thousands of money manager and trader collapses fall into the “not willing to admit fault / learn from mistakes” category.

Posted by Sprizouse | Report as abusive
 

I can see how investors would prefer Gross focus on corporate bonds given the long-term credit premium. That’s not how PIMCO markets the fund, but so be it.

However, in 2011 the Total Return Fund has done poorly even compared with corporate bonds. Year-to-date the Total Return Fund is up 3.1%. The iShares Barclays Intermediate Credit Bond ETF (CIU), which has a similar duration as the Total Return Fund, is up 5.2% for the year.

I agree nine months is not a convincing amount of data. I still wonder whether this is the beginning of the end for Bill Gross’s seemingly unassailable reputation, à la Bill Miller.

Posted by Stevensaysyes | Report as abusive
 

I can see how investors would prefer Gross focus on corporate bonds given the long-term credit premium. That’s not how PIMCO markets the fund, but so be it.

However, in 2011 the Total Return Fund has done poorly even compared with corporate bonds. Year-to-date the Total Return Fund is up 3.1%. The iShares Barclays Intermediate Credit Bond ETF (CIU), which has a similar duration as the Total Return Fund, is up 5.2% for the year.

I agree nine months is not a convincing amount of data. I still wonder whether this is the beginning of the end for Bill Gross’s seemingly unassailable reputation, à la Bill Miller.

Posted by Stevensaysyes | Report as abusive
 

Have you taken stock of Krugman’s critique?
http://krugman.blogs.nytimes.com/2011/08  /30/who-you-gonna-bet-on-yet-again-some what-wonkish/

It appears that part of what motivated Gross’ bad bet was a lack of understanding of how interest rates work in a liquidity trap. Gross didn’t make a bad guess in an uncertain environment; his company relied on bad theory, despite the availability of a good one that has done quite well over the last two to three years.

Posted by Auros | Report as abusive
 

I was with Bill Gross when he recommended buying higher yield bonds from foreign countries and selling treasuries. Of course nobody expected that the market would push treasuries to lower yields so quickly. The question then is, why is he buying treasuries now and not staying with the foreign bonds which in theory carry higher value over the long term?

Posted by wetlands | Report as abusive
 

I’m with Auros: Gross’s mistake does not fall into the category of reasonable. Krugman had a coherent argument _at the time_ why what Gross thought would happoen would, and Krugman was right. All Gross and Paulson have on their side is ‘common sense’, if when these guys fail, they fail because they followed ‘common sense’ arguments, that suggests that when they succeed, they also follow ‘common sense’ arguments, which means that when they succeed, it is luck (Paulson’s coup with mortgages was not based on ‘common sense’ but on a well argued technical analysis of a problem with the market).

Further, Krugman has been usually right (i.e. on the basis of historical evidence, not theoretical opinion). It has been observed that one of the most effective ways to run a macro hedgefund this last few years has been simply to read Krugman’s column, and then do what it suggests. If Paul were running a macro hedge fund he would have delivered high and non- volatile profits these last few years, and he has a coherent theory why.

Posted by seanmatthews | Report as abusive
 

Seanmatthews. Krugman is brilliant, but no John Maynard Keynes. Keynes would have speculated on it and also delivered his judgement in a much more arrogant fashion.

I think Gross mistake falls into the ‘market can stay irrational longer than you can remain solvent’ category. When tradebalance oriented players like the PBoC and the Fed as extended arm of the US are in the market with unlimited funds, then price discovery will not work as expected. These players are not interested in a return on their investment and yet are the biggest buyers standing right next to you at any auction. Short term bidding up their quary or buying ahead of them may make sense. Long term you will end up with their intended return. Zero or negative. That is the stated mission for your competitors.

Posted by Finster | Report as abusive
 

“These players are not interested in a return on their investment and yet are the biggest buyers standing right next to you at any auction.”

…which is why sane investors should shun bonds at this point.

Does Gross have the option of moving into other asset classes? Dividend stocks have done pretty well recently.

Posted by TFF | Report as abusive
 

“Does Gross have the option of moving into other asset classes?”

It’s a bond fund and will be measured relative to other bond funds. He can produce guidance with those optics but people don’t invest with Gross for his knowledge of small cap mining stocks.

The guy is paid to know the bond market and he is ruing his recent judgement. That shows incredible gall but I don’t yet see what he’s doing about it. Perhaps he’s off to Princeton for tea and crumpets?

Posted by jesse1 | Report as abusive
 

“It’s a bond fund and will be measured relative to other bond funds.”

Too bad… Because as Finster stated, the bond market right now is irrational, and being driven by forces that are not concerned with investment returns.

To me this is akin to observing in 1998-1999 that the tech stocks were irrationally valued. If you had gone short on the Nasdaq in January 1999 at 2500, you could have made a heck of a lot of money by the end of 2002 — but you would have faced massive margin calls in early 2000 as the index topped 5000.

Comparing your investment returns to the market is not always wise. It is unrealistic to expect to participate in a frothy rally yet still escape the bursting of the bubble unscathed. Better to sit out both sides of that market.

It is only a mistake if Gross reverses himself now.

Posted by TFF | Report as abusive
 

The notion put forth by Krugman that Gross was simply and foolishly wrong because he ignored the basic logic of a model (IS-LM in this case) is itself a form of hubris.

Gross didn’t screw this up because he didn’t understand the economics or how bonds trade. He gets them just fine. (And jesse1, Krugman’s right that McCulley WAS a big loss, but Gross has got more than a few insanely sharp macro guys at his disposal…)

The “problem” was that, whether you think it foolish or not, Gross worried that the models and historical precedent would be superceded by unusual market psychology, and that…this time would be different. I’m not going to try and describe that in fine detail, but I think most of you probably know what I mean (?)

Posted by fixedincome | Report as abusive
 

Oh, and by the way – nobody (but a very, very few)running a diversified bond portfolio wanted to own TSY at 2.X%, even with the risk of a rally.

Posted by fixedincome | Report as abusive
 

“Gross worried that the models and historical precedent would be superceded by unusual market psychology”

Gross was in effect making a bet against what a particular model predicted was going to happen. There are two things Gross could have done here: admitted he and his team didn’t understand the macro situation properly, or simply state that his predicted outcome _could_ have plausibly happened due to irrationality, madness, or whatever and he just lost the bet this time. Gross is rightly introspective but it doesn’t mean Krugman was “right”, only that the Hicks model — amongst others — worked rather well ex post and Gross should ask his advisory team about that.

Posted by jesse1 | Report as abusive
 

I’m with Auros, opposed to Felix.

Gross is to be criticized not merely for making a trade that proved to be a huge loser, but because his model of how the world works is/was much less-good than others’(like Krugman’s), which he dismissed in favor of his own pet-theory.

Invest with Gross and you’re long “the conventional wisdom” — as if that were something worth paying for instead of reading about in the pages of Barrons Roundtable & elsewhere.

I don’t understand why bloggers & the MSM adore Bill Gross when I think he’s a bully who narrowly eluded serious reputational & criminal charges:

http://www.bloomberg.com/news/2010-12-30  /pimco-to-pay-92-million-to-settle-futu res-lawsuit.html

Gross’ dasein (his way of ‘being in the world’) will eventually undo him: he’ll be spectacularly wrong again and/or unable to beat the next criminal rap. His mentalité is not worth paying a premium for. Sell BG.

Posted by dedalus | Report as abusive
 

Both short-term maturity bonds and long-term maturity bonds are out of favor as the economy presently stagnates. The result both the value and the yield is down.

Posted by kritik1 | Report as abusive
 

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