Are You Better Off Without "The Bond King"?

2013-01-10

by Eric D. Nelson, CFA

 

Bill Gross is among the most famous investment managers in today’s market.  He oversees almost $300B in the Pimco Total Return mutual fund including various spinoffs (a number of different share classes, sub-advised strategies, separately managed accounts, an ETF, etc.), which is by far the largest mutual fund in the country.  By comparison, the next largest fund is the S&P 500 ETF with only $130B in assets.  The assets of the two largest money market funds in the country, Fidelity and Vanguard respectively, still don’t add up to those in Pimco Total Return, even though there is an abnormally high amount of dollars sitting in money market cash accounts today. 

 

This $300B didn’t get there by accident.  Bill Gross has built an enviable track record over the last 25 years at the helm of the Total Return fund.  The institutional version of Pimco Total Return (PTTRX) has outperformed the Barclays Aggregate Bond Index by over 1.1% per year since 1987—a notoriously difficult task that Gross has done fairly consistently, earning him the nickname “The Bond King” (yes, you read that right: indexes are so ruthlessly difficult to outperform, doing so by just 1% qualifies as an exceptional result).  Other versions of the mutual fund and the separately managed account come with higher fees which have eaten into this outperformance, but those who have been able to meet the higher $100K minimums of the institutional share class have been well rewarded.

 

Despite its actively managed approach, which normally does not produce high enough returns to cover the costs, one would assume this track record would make the strategy an obvious choice for an investor looking for a low-risk investment portfolio, or for a balanced investor weighing the options for the “core” of their bond allocation.

 

Surprisingly, a closer look at the Pimco Total Return Fund on its own and within the context of a balanced portfolio reveals that when we apply basic investment theory and make suitable risk-adjusted comparisons to a traditional asset class portfolio, there doesn’t appear to be any benefit to investing with "The Bond King".

 

Table 1 looks at the returns of the Pimco Total Return Fund compared to the Barclays Aggregate Bond Index (“Total Bond Index”) and the DFA Intermediate Government Fund since 1991 (the first year of operation for DFIGX).  The Total Bond Index is the bogey most managers of intermediate-term bonds will compare themselves to, while the DFA Intermediate Government Bond Fund has the same approximate average maturity (5-6 years) as Pimco, but avoids some of the Pimco Total Return's risks by not holding corporate bonds or higher yielding “junk bonds”, which tend to perform more poorly during periods of stock market declines.

 

TABLE 1: Bond Portfolio Risk and Return (1991-2012)

Fund/Index

Annualized Return

Risk (Standard Deviation)

# of Down Years

% Decline During Down Years

Pimco Total Return Fund (PTTRX)

+8.2%

5.6

2

-1.9%

Barclays Aggregate Bond Index

+6.8%

4.8

2

-1.9%

DFA Intermediate Government Fund (DFIGX)

+7.1%

6.4

3

-3.0%

20/80 Asset Class Portfolio

+8.6%

5.5

1

-3.0% (-0.8%)

 

Over this period, the Pimco Total Return Fund has turned in a slightly better-than-inception result of 1.4% more than the Barlcays Aggregate Bond Index and 1.1% more than the DFA Intermediate Government Fund.  A combination of greater exposure to corporate bonds and Bill Gross’s active decisions have paved the way.  But adding corporate bond risk to a default-free bond portfolio like the DFA Intermediate Government Fund is not the only way to enhance expected returns.  At the level of 100% bonds, we also know that adding small amounts of stocks to a low-risk bond portfolio has increased returns without materially increasing portfolio risk because of the diversification benefit from stocks and bonds moving up and down at unique times.

 

And this is exactly what we find in the last row of Table 1.  If we add 20% in stocks (diversified globally across large/small and growth/value companies using the indexes and live equity funds from DFA) to the remaining 80% in the DFA Intermediate Government Fund, we find that the return of this ultra low-risk portfolio climbs to +8.6%, or 0.4% per year more than the Pimco fund by itself.  At the same time, the 20/80 Asset Class Portfolio has less risk than 100% in the DFA or Pimco bond funds as measured by standard deviation or downside losses.  While Pimco has declined twice since 1991, the 20/80 mix only fell on one occasion.  In the years where Pimco Total Return lost value, it fell -1.9% vs. just -0.8% for the more balanced 20/80 portfolio.

 

So if we apply basic investment theory and combine it with a well-designed asset class allocation and adjust for risk, we find the stand-alone returns of "The Bond King" and his Pimco Total Return Fund fall short.

 

What if we look at using the Pimco Total Return Fund as the bond component of a traditional 60% stock and 40% bond allocation in Table 2?

 

Table 2: Balanced Portfolio Risk and Return (1991-2012)

Portfolio

Annualized Return

Risk (Standard Deviation)

# of negative years

% Decline During Down Years

60/40 w/Pimco Total Return

+11.3%

12.2

3

-9.1%

60/40 w/DFA Int’d Government

+10.4%

10.5

3

-6.7%

70/30 w/DFA Int’d Government

+11.6%

12.9

3

-9.9%

 

 

The results are about what we would expect.  The Pimco Total Return Fund has had higher returns than a lower-risk bond portfolio such as the DFA Intermediate Government Fund, but that higher return/risk has also meant the balanced 60/40 portfolio using Pimco has had higher risk and greater losses during downturns.  In the case of the 60/40 portfolios in row 1 and 2, we see almost 2% more standard deviation and 2.5% per year greater losses for the portfolio that included Pimco.

 

But if higher returns at the expense of higher risk is what we are after, it is generally more efficient to simply hold less in bonds and more in stocks, where expected returns are highest.  Indeed, the third row highlights a balanced portfolio that uses the high-quality DFA Intermediate Government Bond fund for its fixed income component, but only has 30% in bonds instead of 40%, with the remaining 70% going to stocks.  Here we find that the 70/30 portfolio has produced an even higher return (+11.6% vs. +11.3% for the 60/40 with Pimco), while not experiencing any additional down years and losing almost the same on average in the years where both portfolios declined.  In short—more in stocks (70%) led to higher returns while higher-quality bonds (30% in DFA Intermediate Government fund) held up better during equity downturns, so you needed fewer of them to do the job.

 

So again, we find basic investment theory combined with a well-designed asset class allocation adjusted for risk leads us to the conclusion that there is no benefit for a balanced portfolio to invest with "The Bond King".

 

Going forward of course, we cannot rely solely on historical simulations.  However, a few obvious issues probably tip the scales even more in favor of avoiding the best-performing, actively-managed bond funds including Pimco Total Return.  

 

#1 The Outperformance Issueeven 20 years of documented outperformance for the Pimco Total Return Fund may not be enough to convince us this will continue.  Since 1991, its outperformance relative to the DFA Intermediate Government Bond Fund is not “statistically significant”, a hurdle we would want to clear before we say for sure that the outperformance is due to skill and not luck.  Doubters of this should be reminded of Legg Mason’s Bill Miller, a stock manager who was able to produce a record 15 straight years of outperformance relative to the S&P 500 Index through what was believed to be similar active management ability as Bill Gross.  Over the next 5 years until his retirement, Miller performed so poorly relative to the S&P 500 that he gave up the entire 15 years of outperformance and retired having slightly trailed the index over his entire career. Further, at almost $300B in assets, it is almost assuredly harder for Bill Gross's Pimco Total Return Fund to “outperform” than when assets were much smaller and opportunities were much easier to exploit.  Finally, after 25 years at the helm, it is unclear how much longer “The Bond King” will continue to manage the portfolio, at which time a new management team will be brought in, further raising the question of how relevant past performance is in predicting future results.

 

#2 The Interest Rate Issuewith interest rates on all bonds at historically low levels, now is certainly not a good time to hold higher-risk fixed income.  Doing so, as the above examples illustrate, always requires a balanced allocation to include a greater overall bond weighting when compared to using lower-risk and more effective risk-reducing high-quality bond portfolios.  If interest rates ever begin to rise and return to more normalized levels, bond prices will surely decline and portfolios that are more heavily invested in fixed income will experience greater losses.

 

#3 The Investor Issue depending on the circumstances, the Pimco Total Return Fund might not be the right fit for a bond allocation regardless of performance.  The above examples assume that an investor is in a low-enough tax bracket or has enough space in tax-deferred accounts where holding taxable bonds makes sense.  If that is not the case, the Pimco Total Return Fund probably isn’t appropriate when compared to using a high-quality, nationally diversified tax-free municipal bond portfolio.  Also, many people who have the greatest desire for a sizable fixed income allocation are retirees requiring a periodic “Portfolio Paycheck” and are more sensitive than average investors to unexpected inflation.  In these cases, a larger commitment to Inflation Protected Bonds would be warranted as compared to the riskier nominal bonds held in Pimco Total Return.

 

There is no denying the popularity and impressive index-beating returns of Bill Gross's Pimco Total Return Fund.  But after applying basic investment policy logic to develop an asset class portfolio with similar risk, considering the current interest rate environment and the unique needs of various types of investors, our conclusion is that you are better off without "The Bond King". 

 

Source of returns = DFA Returns 2.0; Morningstar Principia

 

20/80 Asset Class Portfolio = 3% DFA US Large Company Fund, 4% DFA US Large Value Fund, 7% DFA US Targeted Value Fund, 2% DFA Int’l Value Fund, 2% DFA Int’l Small Value Fund, 2% DFA Emerging Markets Value Fund (DFA indexes prior to fund inceptions from 1991-2000), 80% DFA Intermediate Government Bond Fund; rebalanced annually.

 

60/40 Portfolio w/Pimco = 9% DFA US Large Company Fund, 12% DFA US Large Value Fund, 21% DFA US Targeted Value Fund, 6% DFA Int’l Value Fund, 6% DFA Int’l Small Value Fund, 6% DFA Emerging Markets Value Fund (DFA indexes prior to fund inceptions from 1991-2000), 40% Pimco Total Return Institutional Fund; rebalanced annually.

 

60/40 Portfolio w/DFA = 9% DFA US Large Company Fund, 12% DFA US Large Value Fund, 21% DFA US Targeted Value Fund, 6% DFA Int’l Value Fund, 6% DFA Int’l Small Value Fund, 6% DFA Emerging Markets Value Fund (DFA indexes prior to fund inceptions from 1991-2000), 40% DFA Intermediate Government Fund; rebalanced annually.

 

70/30 Portfolio w/DFA = 10.5% DFA US Large Company Fund, 14% DFA US Large Value Fund, 24.5% DFA US Targeted Value Fund, 7% DFA Int’l Value Fund, 7% DFA Int’l Small Value Fund, 7% DFA Emerging Markets Value Fund (DFA indexes prior to fund inceptions from 1991-2000), 30% DFA Intermediate Government Bond Fund; rebalanced annually.

 

Past performance is not a guarantee of future results.  The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles.  They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only.  Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Clients’ investment returns would be reduced by the advisory fees and other expenses they would incur in the management of their accounts.  Past performance is not a guarantee of future results, and there is always the risk that an investor may lose money.  Indexes are not available for direct investment.