Part 2 of 4 on Bond Market ETFs

In the first installment of this series we talked about several new Bond Market ETFs which have come to market recently.  In todays article we will take a deeper look at the one which is getting the most attention, PIMCOs Total Return ETF, the BOND.

On March 1st PIMCO launched an ETF version of the world’s biggest mutual fund. The PIMCO Total Return Fund. The ETF trades under the symbol BOND, and can be purchased for around $100 per share. There has been a far amount of negative press surrounding the launch, which is the topic of todays installment.

I would like to divide criticisms of the fund into three camps, starting with what is in my opinion the most serious.

Argument 1: Now Is The Wrong Time To Invest In The ETF

The article, “PIMCO Total Return ETF Launches At a Bad Time ”, written by Jeff Reeves of InvestorPlace.com makes the argument that we are at the tail end of a 30 year bull market in bonds. When PIMCO Funds launched the Total Return Fund in 1987, long-term treasuries were yielding around 9%. The decline from 9% to their current rate of 3% was a very profitable one for buyer of longer dated bonds (as yields fall, bond prices rise).

The biggest component of the Total Return Funds profitability was not the acumen of Bill Gross, but being in the right place at the right time. In short, the argument goes now is not the right time to be in bonds, wether the invesment vehicle is an ETF, mutual funds or direct holdings. Legendary investors including Warren Buffet and Larry Fink have also made statements supportive of this viewpoint.

Bill Gross has a response for this argument.

He also believes the days of “12%” returns on bond investments are a thing of the past however, just because the bull market is over, does not mean that we are headed into a bear market (where interest rates rise continually and bonds fall in value). We could be headed into a pro-longed period of low rates. In other words, the priority  of the PIMCO Total Return Fund and BOND ETF is shifting towards producing low risk income, versus capital gains.

Argument 2: The PIMCO Total Return Fund Is Managing Too Much Money

The PIMCO Total Return Fund is already the largest mutual fund in the world at $250 Billion.  To put that into perspective, the fund needs to make $2.5 billion to move returns by 1%. This has several important implications:

1. They only can look at really large opportunities for this fund. They are too large to generate significant returns by bargain hunting or short-term trading, because the amount of money that can be deployed in these types of strategies is very small in comparison to the size of the fund. To make money they need to be right on the big picture asset allocation. FED policy and the future shape of the yield curve .
2. If PIMCO changes its mind on the big picture, it can be very difficult to re-deploy money in a timely fashion. Elephants cannot quickly turn around.

Managing more money with an ETF that uses THE SAME STRATEGY will make these challenges even more difficult.

Argument 3:  BOND is simply a lite version of the Mutual Fund

The focus of this argument is that the mutual fund has the ability to use derivatives and the ETF does not.  Proponents of this position say that because the ETF cannot make use of derivatives its returns will be lower than the Mutual Fund.

There are several reasons why I don’t think this is true. Bill Gross has said that he plans to cut down on the use leverage (derivatives) based on his long-term view of bond market behavior. His strategies are now “defensive” (capital preservation)  versus “offensive” (returns focused). A derivative is an offensive tool not a defensive one and therefore not an important part of new playbook. If Gross thought the use derivatives was important, he could have registered the ETF with CFTC, which is not a big deal.

So with all these arguments against launching the ETF why would PIMCO do it?