What’s driving the Total Return ETF?

By Felix Salmon
July 18, 2012
it was clear what the biggest risk was:

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When Pimco’s Total Return ETF launched earlier this year, it was clear what the biggest risk was:

The inability of the PIMCO Total Return ETF to use derivatives will prevent a perfect correlation and affect performance. The size of that difference will be watched closely and will play a role in the format’s acceptance by investors.

Peter Lewis, executive director of liquid markets at Nomura Securities International in New York, said while some deviation will not have a big effect on the acceptance of active ETFs, a wide gulf would be a point of objection.

The total return ETF is supposed to mimic the performance of Bill Gross’s flagship Total Return Fund. And the bad news is that it has failed to do so, by an enormous margin: there’s a whopping 350bp gap between the two already, and that’s just performance since March 1. Oops.

But here’s where things get interesting: the Total Return ETF has actually outperformed its namesake fund, rising 7.7% during a period when the older fund rose just 4.2%. And suddenly the investors who were worried about basis risk don’t seem to be nearly as worried any more:

Bill Gross’s Total Return Exchange Traded Fund has doubled its assets in less than two months, as performance trumped that of the world’s largest mutual fund, whose strategy it mimics…

Pimco Total Return ETF (BOND) reached $1 billion in net assets on May 21. Because the ETF is still much smaller than the mutual fund version, it can snap up notes with the biggest potential returns.

This is worrying on three different levels. First of all, it shows that investors still haven’t learned one of the first lessons of financial markets, which is that anything which can outperform substantially is also at risk of underperforming substantially. If the ETF is doing much better than the bond fund it’s meant to mimic, that’s not some happy reason to pile in, it’s a big red flag.

Secondly, this shows that sophisticated, actively-managed ETFs simply can’t do what they’re designed to do. Pimco is deliberately vague on the question of whether the ETF is meant to replicate the larger fund, or whether it’s just meant to follow the same strategy. But either way, a 350bp difference between the two, in the space of just four months, is pretty definitive proof that they’re very different animals indeed.

And finally, it’s evidence that the $263 billion Total Return mutual fund is simply too big at this point. Here’s the theory:

“It’s very difficult to beat the market when you are the market,” said Bonnie Baha, head of global developed credit at Los Angeles-based DoubleLine Capital LP, which oversees $38 billion. “Any choices you make will have an outsized impact when you’re smaller and more nimble. It stands to reason that there will be more opportunities that you can take and fly below the radar”.

I’m not completely convinced: the Total Return Fund can move very fast, when Bill Gross is so inclined. On the other hand, while there are good reasons why you might want to be invested in a $2 billion fund rather than a $20 million fund, it’s much less clear why an investor is better off in a $200 billion fund than in a $2 billion fund. Economies of scale, at some point, become diseconomies of scale.

And then there’s the simple question of Bill Gross’s finite attention budget: if he’s picking out smaller opportunities for his baby ETF, does that mean that at the margin he’s neglecting his main charge?

On top of all that is the fact that it seems to be decidedly non-trivial to work out the difference in performance between the ETF and the main fund. On July 6, for instance, Yahoo Finance reported that the ETF was up 6.2% since March 1, while the Total Return Fund was up 3.2% — a difference of 300bp. The same day, Bloomberg had the same 3.2% return for the fund, but said the ETF was up 6.8%, for a difference of 360bp.

All of which says to me that it’s very early days to be investing in the young and decidedly untested asset class of actively-managed ETFs. Pimco’s big institutional clients, with their billions of dollars invested in the main Total Return Fund, certainly aren’t moving their money over to the ETF just yet. If and when they do, it might be time to revisit. But for the time being, it’s probably best to just observe BOND’s nascence from the sidelines. Like all babies, it’s pretty much impossible to tell how it’s going to grow up.

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