(Bloomberg News) Bill Gross is starting a new version of his Pimco Total Return Fund that will rely less on derivatives and leverage, two of the tools he used to build Total Return into the world's largest mutual fund.

The new fund, identified as Pimco Total Return Fund IV in a February regulatory filing that details the changes, will forgo high-yield debt, borrowing to create leverage, and investing in options. It will serve as an alternative to rather than a replacement for Pimco Total Return, which had $237 billion in assets as of last month.

Gross, the co-founder of Pacific Investment Management Co. in Newport Beach, California, is tinkering with a strategy that helped him beat 98% of rivals over almost 24 years and attract $25.1 billion of new deposits last year. With Gross forecasting an end of the three-decade bond rally, Pimco may be targeting investors who prefer a more conservative approach over the risks associated with excess yields, according to Francois Otieno, a senior fixed-income analyst at Hewitt EnnisKnupp, which advises institutional investors.

"The total return fund is the largest mutual fund in the world, yet very few underlying investors have a clue on how their strategy is executed," Otieno said in an interview from Chicago. "There is an appetite for a more conservative strategy in the marketplace."

Mark Porterfield, a spokesman for Pimco, said the firm can't comment on the new fund while its disclosure documents are being reviewed by the U.S. Securities and Exchange Commission. Gross, 66, didn't respond to telephone calls and e-mails seeking comment.

No Limits

Pimco Total Return has produced average annual returns of 8.42% since starting in May 1987, a performance that ranks it seventh out of 353 bond funds, according to Morningstar Inc., the Chicago-based stock and fund research firm. Its benchmark, the Barclays Capital U.S. Aggregate Index, has had average annual returns of 7.26% from April 30, 1987, through Feb. 28 of this year, according to data compiled by Bloomberg.

The fund benefited from a bond market rally that dates back to the early 1980s, as well as Gross's ability to discern macroeconomic trends and the wide latitude he has to boost returns through complex instruments and strategies. Pimco Total Return may invest "without limitation" in derivatives, including options, futures contracts or swap agreements, according to the fund prospectus.

$2.38 Trillion

Pimco, founded in 1971, has used derivatives as an integral part of its strategies since 1980, primarily to manage risk and take advantage of market inefficiencies, according to a July 2009 report by Hewitt EnnisKnupp. Pimco Total Return's "most unique aspect," according to the report, "is its extensive use of derivative securities."

At the end of 2008, the fund's portfolio, including derivatives, had a gross notional value of $2.38 trillion and a market value of $133.1 billion, Hewitt EnnisKnupp said in the report. That resulted in an accounting leverage, or total assets to net capital, of 17 times, the report said.

The Hewitt EnnisKnupp report shows Pimco Total Return's accounting leverage fell to 4 times at March 31, 2009. Gross's firm argues that as long as the fund's risk profile in aggregate is similar to that of its benchmark, it doesn't employ leverage on an "economic" basis, according to the report.

Clients who rely on Pimco as their sole bond manager "may want to" consider diversifying into more traditional fixed- income managers or an index fund, the report said.

'Complex Strategy'

"EnnisKnupp remains comfortable with the Pimco Total Return Fund and its related strategies," according to the report. "But we acknowledge that this complex strategy relies heavily on derivatives and may not be ideal for all investors, particularly those investors that view their fixed-income portfolio as an anchor to windward as opposed to a source of total return."

The restrictions imposed on Pimco Total Return IV would create an alternative that more closely mirrors the benchmark Barclays aggregate index, said Adam Cohen, director of fixed- income research at Fortigent LLC, a Rockville, Maryland, consultant to investment advisers, family offices and bank and trust companies.

It will seek to invest at least 80% of total assets in bonds and other debt securities, according to a Feb. 11 SEC filing, whereas the main Pimco Total Return has a lower target of 65% that can be met through the use of forwards or derivatives, including options, futures and swap agreements.

While Pimco Total Return seeks to maintain an average portfolio duration that is within two years of the Barclays aggregate index, the new fund will try to stay within one-and-a- half years of the benchmark.

Client Withdrawals

"This is for investors who are looking to hold a more traditional fixed-income fund," said Cohen. "It makes the fund more constrained and more targeted towards the aggregate" he said, referring to the Barclays aggregate index.

Pimco Total Return's growth reversed late last year amid signs that the 30-year bond market rally was coming to an end, a possibility that Gross himself raised in an Oct. 27 commentary on Pimco's Web site. After taking in a net of $32 billion from investors during the first 10 months of 2010, the fund recorded net redemptions of $9.45 billion between November and January, according to Morningstar. November marked the first time in two years that withdrawals exceeded share purchases.

Flagship Fund

Gross set up two other versions of his flagship fund in 1991. Pimco Total Return II is barred from investing in high- yield bonds while Pimco Total Return III is a socially conscious fund that avoids investing in industries such as tobacco, gaming and spirits. Apart from those limitations, their terms are identical to those of the initial Total Return Fund, including the ability to make unlimited investments in derivatives, subject to applicable securities laws and any caveats in their governing documents.

The $3.3 billion Pimco Total Return II produced average annual gains of 7.9% during the past five years, compared with 8.3% for the original Pimco Total Return, according to data compiled by Bloomberg. Its management fees are 0.50% of assets, compared with 0.46% for institutional shares of the larger fund.

Pimco Total Return IV, the latest edition of Gross's fund, will hold only investment-grade securities, can't have more than 15% of total assets invested in securities denominated in foreign currencies, and will under normal circumstances limit its foreign currency risk to 5% of total assets, the filing shows. The comparable ceilings for the existing Pimco Total Return are 10% of total assets in high-yield securities, 30% in foreign-denominated debt, and a 20% ceiling on overall currency exposure.

No Options

The new fund may not borrow to create leverage, though it can take out temporary loans equaling as much as 10% of assets to meet redemptions or for emergency purposes. In contrast, the existing Pimco Total Return may borrow money "to the extent permitted under the 1940 Act," generally defined as 33% of net assets.

While Pimco Total Return may invest "without limitation" in derivatives, the new version of the fund will "seek to limit" exposure to interest rate swaps to 10% of total assets and will cap its credit default swaps at 5% of total assets. The new fund "may not invest in options," according to the SEC filing, nor can it engage in reverse repurchase agreements.