Fund buys S&P 500 futures, then tries to beat the index with bonds.
Can PIMCO's three-year-old StocksPlus Total Return Fund continue its stellar performance? Over the three years ending in September 2005, it has outperformed the S&P 500 by 2.1% in annual return. As a result of its solid performance, it earned a five-star rating by Morningstar Inc.
The fund typically invests 5% of the portfolio in stock index futures and the rest in cash, bonds and fixed-income derivatives. Bill Gross, portfolio manager and a PIMCO managing director, primarily invests in three-month S&P 500 futures contracts to obtain equity market exposure. Unlike stocks, futures do not require payment up front. But a money market financing cost is built into the futures contract price that typically approximates the three-month London Interbank Offered Rate (LIBOR).
The end result is that the equity futures provide the return of the equity market index minus the money market cost.
Gross says that he invests the cash in a portfolio of money market securities that generates a total return that approximates LIBOR. The cash investment covers the cost of the futures. So the StocksPlus portfolio should match the return on the stock market.
The extra return the fund generates is due to Gross' bond and fixed-income derivatives investments. He has more flexibility with this fund's bond portfolio than with his flagship Total Return Fund to make sector, duration and yield curve moves.
"Our approach involves actively managing a bond portfolio with the goal of outperforming money market rates and therefore the S&P 500 Index," he says. "Our equity exposure is identical to the S&P 500 Index. As a result, the fund is not likely to be subject to the same type of individual stock price volatility, and the resulting stock selection risk, as a fund that relies on stock selection to generate excess returns."
Eric Jacobson, a Morningstar senior analyst, believes that the fund is a good substitute for an S&P 500 index fund. Nevertheless, he recommends that investors stick with the fund's institutional share class, which can be purchased through a managed account or pension. The reason: The 1.19% annual expenses on the A or B share classes are too high, so the retail shares may have a hard time outperforming low-cost index funds. The institutional share class sports an expense ratio of just 0.74%.
"If you buy this as a substitute for an S&P 500 index fund and have a long-term orientation, it is a good strategy," he says. There have been periods when the fund has underperformed. "The biggest problem is that cost hurdle for the retail A and B shares. It isn't worth it."
At this writing, the fund had 46% invested in cash, 22% in bonds and the rest in stock index futures and fixed-income and currency derivatives, such as Eurodollar futures, according to Morningstar.
The fund's duration was just 3.8 years. Eighty-three percent of the fund's bond holdings mature in five years or less. Top fixed-income sector holdings include mortgage-backed bonds, U.S. Treasury bonds and agency bonds, foreign bonds, corporate bonds and emerging market bonds, according to PIMCO.
Over the past three years, the fund has outperformed the stock market due to its fixed-income positions. Both U.S. bonds and foreign bonds outperformed as interest rates declined worldwide.
"We had U.S. yield curve exposure in the intermediate-to-longer end where rates fell," Gross says. "Our decision to allocate a portion of our interest rate exposure to Europe, together with our exposure to TIPS (Treasury Inflation Protection Securities) and emerging market debt, resulted in attractive returns over the course of the past three years."
But Gross admits that he did not make all the right moves. The fund could have improved performance if he had more exposure in corporate bonds, but the move was too risky due to the tight yield spread between corporate bonds and U.S. Treasury bonds.
"Our entire investment philosophy is based on a longer-term perspective together with significant diversification across the different sources," he says. "It may be true that our excess returns would have been higher for a given period if had we allocated more to a given sector or strategy. Greater allocations to corporate bonds may have produced higher returns over the past three years."
Although the fund performed well, there is no free lunch. The fund can be volatile. In the short term, the fund has experienced large losses. For example, PIMCO's June 2005 quarterly review, noting the best and worst returns since the fund's inception, said that the fund lost 15.21% during the three-month period ending in September 2002. Meanwhile, during the three-month period ending in June 2003, the fund gained 16.89%.
Morningstar's Jacobson stresses that although Gross is the best bond manager in the business, investors depend on him to make the right moves-the fund could underperform if Gross makes too many mistakes.
Currently, Gross says that S&P 500 futures contracts represent 90% of the fund's equity exposure. On the bond side, he has increased his exposure to mortgages and selected emerging market issues. He has reduced exposure to Treasury inflation protected bonds. He also took profits in European bonds. Meanwhile, his yield curve strategy focuses on the use of money market futures and options as appropriate.
Gross, citing the global economy, expects the fund to outperform the S&P 500.
"Our outlook over the next three to five years is relatively positive for high-quality bonds," he says. "Secular, disinflationary forces that include the global free-trade-based economy and an ample supply of cheap Asian labor should support an environment that includes low and even declining interest rates."
He also expects the U.S. bond market to be bolstered as Asian central banks continue to invest in Treasury bonds to prevent their currencies from appreciating relative to the dollar. This should help support their export markets.
"This demand for Treasuries helps keep rates lower than might otherwise be the case," he says. "A heightened focus on asset/liability matching by pensions and other institutional investors in the U.S. and abroad will also likely support bonds."
Gross's biggest worry is that the fixed-income markets are overvalued today. "My biggest concern in general, right now, is that most of our risk asset markets are overvalued-and potentially significantly overvalued," he says. "This poses serious risks for our domestic and global economies. Our portfolios are defensively positioned with respect to fixed-income securities that would be most likely to suffer in the event of an economic slowdown and/or related unwinding of leveraged structures in risk-oriented markets."
In addition, the fund may not perform well in a flat or inverted yield curve environment, because the fund many not earn the total return it expects on its bond holdings. Plus, the inverted yield curve would result in higher cash costs.
The greatest risk to the fund, however, would be stagflation-falling stock prices due to a recession, and rising interest rates due to higher inflation. Under these circumstances, the fund's stock futures positions would decline, the cost of its futures exposure may rise and its bond values could decline.
Gross says that if we experienced a period of stagflation like that in the late 1970s and early 1980s, he would shorten the duration of the bond holdings to one year. This would limit losses due to rising interest rates. But he does not believe we will experience an economy with "rapid, largely unanticipated, significant increases inflation."
"The fund will absolutely be negatively impacted in the event that falling stock prices result in a negative S&P 500 Index total return," he says. "On the other hand, rising short-term interest rates may or may not negatively impact the fund, depending on our yield curve positioning. In the event that bond market returns are negative or lower than money market rates due to a sharp, unanticipated rise in inflation ... this would most likely have a negative impact on our StocksPlus Total Return excess returns."
Playing Two Sides
December 1, 2005
Fund buys S&P 500 futures, then tries to beat the index with bonds.