[This article will appear in the March 2012 edition of
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: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
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.
'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
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
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
Not everyone agrees. Michael Paciotti, chief investment officer
at Integrated Capital Management Inc., sees the lack of derivatives
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
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