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
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