Pimco's New ETF: A Gross Mistake?

Bonds have paid so little income for so long that you'd think no one would be interested in them anymore. With Treasury bonds and even many high-quality corporate bonds not even paying enough to keep up with inflation and taxes, let alone provide a positive real after-tax return, the only good thing about bonds lately is that they've generated big capital gains for long-term holders -- capital gains that could easily turn into losses during the next upswing for rates.

But the newest bond ETF from Pimco and its bond guru, Bill Gross, has attracted huge amounts of interest. After only five trading sessions, the ETF already had $134 million under management, giving it the ninth most assets of any actively traded ETF. If bonds aren't meeting anyone's needs right now, why are so many people interested?

A longtime leader
In part, the answer lies in Gross' track record. The Pimco Total Return ETF (NYS: TRXT) is a rare actively managed exchange-traded fund, and it's designed to closely mimic the performance of the well-regarded Pimco Total Return mutual fund. Although the ETF just came out last week, the Total Return fund is the largest mutual fund, with roughly $250 billion in assets under management.

There's no disputing the long-term excellence of Gross' performance with Pimco Total Return. Over the past 15 years, the fund has beaten its benchmark by more than a percentage point and beaten its peers by even more, putting it in the top 2% of all bond funds since 1997.

How did Gross manage to outperform so strongly? A look at the fund reveals a few hints:

  • You'll find bonds of all different types in the fund, and the allocations don't stay constant. Among the fund's holdings are Treasuries, U.S. agency securities, corporate bonds, and even foreign sovereign debt.

  • Pimco Total Return uses various derivatives to create a leveraged portfolio. In this way, the fund follows a similar strategy to what mortgage REITs Annaly Capital (NYS: NLY) and Chimera Investment (NYS: CIM) use, although Pimco's return advantage doesn't appear to be nearly as dependent on interest rate spreads as Annaly and Chimera. But the fund isn't always exposed to such risk; Gross merely has it as an option during certain market environments.

In essence, rather than being content with a standard arsenal of different bond investments, Gross can push the envelope to get outsize performance -- and most of the time, he's been successful.

All good things come to an end?
But even with Gross' long-term track record, he's hit a rough patch recently. Over the past three years, Pimco Total Return fell back into the middle of the pack. And last year, an ill-timed bet against Treasury bonds cost the fund, which dropped to the bottom 13% of bond funds according to Morningstar. That led to a mass exodus of investors last year, with $5 billion in redemptions during 2011.

So far in 2012, however, the fund is back to its winning ways. And clearly, ETF investors hope that Gross will regain his magic touch and deliver better returns in a bond market that's very stingy with income right now.

Will active management save you?
ETF investors hoping to avoid bond market volatility should understand that Gross hasn't managed to smooth his returns entirely. Overall, the fund's annual returns have risen and fallen with the overall bond market. If bonds collapse, then you're not likely to avoid losses entirely just by holding the Pimco ETF.

But even though they're less expensive, passive bond index ETFs Vanguard Total Bond (NYS: BND) and SPDR Barclays High Yield Bond (NYS: JNK) will simply ride bond prices down when rates rise. By contrast, it's possible that Gross will take steps to at least slow the descent. That won't necessarily mean strong absolute returns, but compared to alternatives, the Pimco ETF may outperform -- even considering an expense ratio that's significantly higher than what you'd pay for an index fund.

An interesting call
The Pimco Total Return ETF is an interesting experiment for which many have high hopes. Some see the ETF as a game changer, ushering in a new era of active ETFs. For now, though, I'd suggest waiting on the sidelines to make sure that the ETF actually tracks its mutual fund counterpart -- and to make sure that Gross has indeed gotten his mojo back after a disastrous 2011.

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At the time thisarticle was published Fool contributor Dan Caplinger pleads guilty to gross punnishness. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy prefers things that come in packages of 144.

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