Tag Archives: PIMCO

In The Market Carnage, One Long-Short Fund Looks Impressive

Some mutual funds short stocks (bet on them to go down) at least with part of their portfolios, and Morningstar has a long-short category with 248 of them. I ran a screen on Morningstar.com’s premium mutual fund screening tool to see which of them had lost 3% or less for the year-to-date period through December 24th and also had a five-star rating, meaning a fund’s volatility adjusted return put it at the top of the category over at least the last 3 years. For the year through December 24th, the S&P 500 Index dropped 10.36% including dividends.

My return criteria were admittedly arbitrary, but hopefully not unreasonable. If a long-short fund is down 5% when the market is down 10% in one period, has the fund failed? It’s not easy to say. But I wanted to be more stringent and see if any funds that had done well against each other for an extended period of time had also weathered the storm the market has delivered recently with a better than -5% return for the year.

First of all, 38 of 248 long-short funds (or only 15%) dropped 3% or less for the year. Also, the category average return was -9.14%, only slightly better than the index’s loss including dividends. That was a little disappointing; it’s unclear that the category is earning its keep.

The fund that made the grade, dropping 3% or less and posting a five-star rating was the PIMCO RAE Worldwide LongShort Plus (PWLIX) fund. The fund has been around since late 2014, and is subadvised by Robert Arnott’s firm Research Affiliates. Arnott and others are listed as portfolio managers.

This is not a typical long-short fund whereby a research team proceeds stock-by-stock, deciding what to buy and what to short on valuation or other factors. First, this funds gets its equity exposure (both long and short) through index-tracking equity derivatives which are collateralized with a bond portfolio. The fund tries to deliver positive returns with its equity exposures, of course, but also through its bond portfolio delivering a higher return than the cost of the derivatives.

Second, this fund is normally long a worldwide index of low volatility, high yielding, and low leverage stocks and short a worldwide capitalization weighted index where stocks are ranked according to the value the market accords them. Market capitalization indexes arguably create distortions, whereby the prices of the largest stocks are unduly elevated and those of the smallest stocks are unduly depressed. That means the combination of being long an index not based on market capitalization and shorting a capitalization weighted index can benefit an investor by owning relatively cheap stocks and shorting relatively expensive stocks.

Besides low volatility stocks outperforming capitalization weighted indices in long terms backtests, the fund can benefit from what it calls “dynamically managed global equity market beta.” In other words, the fund typically has more equity exposure when markets are less volatile and less when they’re more volatile. The fund’s literature argues that these three sources of return – the low volatility equity income strategy, the actively managed absolute return bond strategy, and the dynamically managed global equity market beta strategy – are uncorrelated.

It’s likely that the correlation argument is true. After all, the low volatility equity income strategy is similar to a value approach to stock investing. The low volatility strategy was devised by a finance professor named Robert Haugen who studied the works of Benjamin Graham and took issue with the assertion of modern academic finance that one had to incur high volatility to achieve a superior return. Haugen showed that high volatility stocks were mostly what Graham called the “glamour” stocks that ran hard for a while, but wound up flaming out. Lower volatility, boring companies that didn’t capture investors’ imaginations (and then disappoint them by not fulfilling extreme expectations) plugged along and eventually produced superior returns.

The dynamically managed global market beta strategy, however, is a kind of momentum strategy. If it’s adding exposure when market are calm, it’s likely adding  exposure when they’re going up – or at least not declining and vice versa.

So the two equity strategies fight against each other to some extent – or complement each other, depending on how you look at it. One potential problem is if low volatility equity income strategies are much in favor now and, therefore, become so expensive that they don’t have much return potential over market capitalization strategies. Then the investor is dependent on the momentum-like dynamically managed beta strategy and the bonds outstripping the cost of the derivatives for return.

But maybe relying on two strategies isn’t so bad. And the fund has acquitted itself well, producing a 7.84% annualized return for the 3-year period through December 24th, 2018. That’s better than the S&P 500 Index’s 6.65% return and amounts to a performance good enough to land the fund in the top percentile of the Morningstar long-short fund category over that stretch. The fund has achieved that superior return with lower volatility — a 6.82% standard deviation of returns compared to a 9.4% standard deviation of returns for the index.

The comparison to the S&P 500 Index — the typical way Morningstar displays returns for long-short funds on its website — may work too much in the fund’s favor lately since shorting international stocks has undoubtedly helped it. But the fund has also been long international low volatility stocks, and, overall, it’s been easier to beat a global index lately than a domestic one. three years is also not a very long period of time, but we don’t have much more history on this fund. Investors will have to make due with that for now in their analyses.

Finally, while the institutional share class’s 1.28% expense ratio isn’t cheap by plain equity fund standards, it is compared to long-short funds, where shorting stocks, which can entail paying dividends, can get expensive in a hurry.

Altogether investors have a long-short option worthy of consideration in this fund, which has the potential to beat the index simply and provide an uncorrelated source of returns in a portfolio.

The Tale Of The Two Bond Kings

(This article originally appeared in Citywire.)

Back in September, I examined the records of the managers that Morningstar nominated as candidates for ‘domestic equity Manager of the Decade’ in 2009. The results were not hugely encouraging. After making that illustrious shortlist, not one manager went on to beat their best-fit index. The Yacktman fund came closest, gliding so smoothly to its 11.43% annualized return from 2010 through August 2018 that it nearly produced the same Sharpe ratio as the S&P 500 index (1.14 versus 1.15 over the past decade). However, it still trailed the index’s return by more than 2.5 percentage points annualized.

Now, though, it’s time to focus on the nominees for the fixed income ‘Manager of the Decade’ award. The results are decidedly better. In 2009, Morningstar shortlisted Dan FussJeffrey GundlachBill Gross, Christine Thompson of Fidelity’s municipal bond funds, and the team on the Dodge & Cox Income fund. The award ultimately went to Gross, but it turns out that he is the only one to have subsequently posted a poor set of results.

It is unclear why Morningstar’s fixed income nominees have fared better than its equity picks. Perhaps, given the relative illiquidity of the bond market, it’s simply easier for fixed income managers to beat their indices than it is for their equity counterparts. Or maybe manager selectors and consultants have an easier job when it comes to identifying talented bond managers. Whatever the explanation, the fund analysts at Morningstar (including me, at the time) certainly seem to have been more successful in having their bond ‘Manager of the Decade’ nominees go on to post good returns in the future.

Masters of their domains

First up is Christine Thompson, who headed Fidelity’s municipal bond operation at the time of the nominations. She is no longer listed as a manager of Fidelity’s funds, but it was obvious that Fidelity’s municipal bond operation had depth and that this was a team nomination. For the period from 2010 through the end of September 2018, the Fidelity Municipal Income fund has posted a 43.7% cumulative return, while the Bloomberg Barclays Municipal Bond index has delivered 39.9% (see Figure 1). Over the past decade, the fund’s 1.09 Sharpe ratio has trailed that of the index (1.13), meaning that it has incurred more volatility to achieve its outperformance. Even so, it would be difficult to say that the fund has carried an unjustifiably high level of volatility.

Next, we have the ‘bond kings,’ Bill Gross and Jeffrey Gundlach, and the Dodge & Cox Income fund. All three deserve to be judged against the Bloomberg Barclays US Aggregate Bond index. There are two caveats with our data here. Gundlach left the TCW Total Return fund in December 2009 and began managing the DoubleLine Total Return fund the following April. Here, I have taken the TCW fund’s 2010 data through April and then hooked it up to DoubleLine’s data starting on May 1 that year. Similarly, for Bill Gross, I took the Pimco Total Return fund’s data from 2010 through October 2014 and then picked up with Gross’s new charge, the Janus Global Unconstrained fund, in November 2014. Gross began his tenure at Janus on October 6, 2014.

No Undue Risk

Realistically, Gundlach has dominated the period since the ‘Manager of the Decade’ nominations. According to the spliced data, he posted a 58.9% cumulative return from 2010 through the end of September 2018. His combination of safe Ginnie Mae bonds and beaten-up, high-yielding Alt-A private label mortgage-backed bonds has worked splendidly.

The team of managers that runs the Dodge & Cox Income fund has acquitted itself well too, delivering a cumulative return of 39.6% versus the index’s 30.7%. Gross, by contrast, has returned just 29.4% over that period (see Figure 2).

And lest anyone suppose that it was reckless portfolio positioning that accidentally produced Gundlach’s heady post-crisis returns, let the record show that he hunkered down with higher quality securities exactly when he should have done in 2008. That year, he piloted the TCW Total Return fund to a top-decile performance in the Morningstar intermediate-term bond fund category, with a 1.09% return.

Finally, the Loomis Sayles Bond fund, led by Dan Fuss, has outpaced the index with a cumulative return of 65.1% versus the Agg’s 30.7% (see Figure 3). However, investors should take this with a pinch of salt. The fund routinely invests in junk bonds and emerging market debt, along with a slug in safer sovereign debt. That makes it more volatile. Indeed, its Sharpe ratio over the past decade through September 2018 is 0.84. Compared with the Agg’s 1.04 Sharpe ratio over the same period, the Loomis Sayles Bond fund arguably hasn’t achieved as attractive a volatility-adjusted return.

Overall, the Morningstar ‘Manager of the Decade’ nominees in fixed income have produced solid results since 2009. Consultants often think small-cap stocks and international markets afford greater opportunities for active management to shine. Perhaps the ability fixed income provides has been under-appreciated.

Rising Rates And Funds

There’s always something else to worry about. For a while now, investors we admire such as Grantham, Mayo, van Oterloo (GMO) and Research Affiliates have been touting the cheapness of foreign stocks, especially emerging markets stocks. This past August James Montier of GMO argued that an allocation to the S&P 500 Index, given its valuation then, counted more as speculation than as an investment. Also, in November, Research Affiliates published a paper questioning whether anyone needed U.S. stock exposure.

Valuations of foreign stocks are indeed more compelling than those of their U.S. counterparts. But U.S. investors must account for other things when venturing abroad, including currency moves. When U.S. investors own a foreign stock that trades on a U.S. exchange, they receive two returns, the return of the stock in its local currency and the movement of the local currency relative to the U.S. dollar. In other words, U.S. investors take on foreign currency exposure when they own foreign stocks. Lately that has provided some pain as the dollar has surged thanks to rising interest rates. From the lows of this year in February, the U.S. dollar has surged more than 4% against a basket of foreign currencies.

And that means investors in foreign stock have suffered, though those stocks have not necessarily performed badly in their local currencies. For example, the MSCI EM Index has dropped 1.72% and 3.97% over the past month-to-date and three month periods, respectively, through May 9, 2018 when translated into dollar terms – in other words, for ordinary U.S. investors without a currency hedge. But in local currency, over the same two time periods, the same index has dropped only 0.73% and 1.46%, respectively.

In the realm of developed markets, the MSCI EAFE Index has delivered a month-to-date and three-month return through May 9, 2018 of -0.07% and 0.37%, respectively, when translated to the dollar. But it has delivered 1.10% and 3.29%, respectively, to investors with a hedge, thanks to the strengthening dollar and weakening foreign currencies.

Currency moves are hard to time, and that means most investors like to stay unhedged or hedged at all times. Is there one of these that’s better? A paper by asset manager AQR argues that, over time, investors haven’t gotten paid for the volatility they’ve incurred from foreign currency exposure. The lesson for long-term U.S. Investors is to hedge their currency exposure. That makes some sense because while currencies move up and down against each other over long periods of time, those moves tend to cancel each other out. There’s no long term gain to be captured from a currency bet.

Now, despite the dollar’s run lately, the greenback looks relatively high versus a foreign basket of currencies over a longer period of time. In that case, foreign currency exposure might actually help. So if investors are expecting the dollar to fall over a longer period of time, they can hedge some prearranged percentage of their foreign stock portfolio.

Some instruments with which investors can gain hedged currency exposure to foreign stocks are the Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) and the xTrackers MSCI Emerging Markets Hedged Equity ETF (DBEM). The first gains exposure to the MSCI EAFE with a currency hedge, and the second gains exposure to the MSCI EM Index with a currency hedge.

May I Please Have Some Yield?

Apart from the esoteric realm of currency hedging, rising rates have also caused rates to, well, rise on short-term debt funds. And that can be a boon to investors – especially those with a penchant to ride out expensive markets with at least some of their money in cash. PIMCO’s Enhanced Short Maturity Active ETF (MINT) might be a decent choice for safety with some yield. It owns high quality short-term debt instruments (Effective Maturity – 0.61 years), including both sovereign and corporate debt, and its current yield is 2.18%. Not all the instruments are from the developed world, and the fund can take a bit more risk than the average money market fund. But the fund doesn’t use options, futures, or swaps and discloses its holdings on a daily basis.

How’s Your Bond Fund Doing?

It’s been a tough year for bonds so far. Of course, a tough year for bonds can be a tough day for stocks. But investors seem equally disturbed by a 2% loss in bonds as by a 10% or more loss in stocks, so it’s worth looking at how bond funds have weathered the most recent storm. We looked at some of the most popular funds that reside in Morningstar’s intermediate term bond fund category. That category contains funds whose duration is moderate and whose holdings tend to be almost all investment grade, and so those funds tend to be the workhorses of most investors’ portfolios.

Through May 1, the BloombergBarclays US Aggregate is down 2.42%. That’s a total return number, so it includes the difference in price plus interest payments. The Morningstar intermediate term bond fund category average is down 2.11%, a slightly better showing likely owing to the higher corporate bond exposure and slightly lower duration of many funds compared to the Treasury -heavy index.

Duration Hurts

First, all of our selected funds have beaten the index so far this year except for the Western Asset Core Bond fund. The fund’s portfolio doesn’t appear unusual, although it has more of its assets in Agency Pass-Throughs than its peers (35% versus 21%), according to Morningstar. It has nearly 22% of its portfolio in Government bonds, according to Morningstar. Almost all of that is in U.S. Treasuries with a small part scattered in U.S. Agencies and Non-U.S. government debt. Nearly 8% of the fund’s portfolio is in emerging markets debt.

However, the fund’s average effective duration, a measure of interest rate risk, is nearly seven years, and that has likely contributed to its underperformance. No other fund’s duration is over seven, and the next highest three are barely over six. Five of the funds have durations around 4 years, and they’ve tended to hold up better this year.

Things Besides Duration Matter Too

Two funds stand out for bucking the trend of duration dictating performance. First, the Delaware Diversified Income Fund clocks in with a duration of 6.09, but the fund has still been able to eke out a gain over the Morningstar intermediate term category average and the Bloomberg Barclays U.S. Aggregate. This fund has traditionally held a lot of corporate bonds, including more high yield bonds than its peers. Currently the fund has 13% of its portfolio in BB-rated bonds (the highest level of junk or high yield), and those have held up better than more highly rated bonds this year. So the fund’s credit risk has likely helped it in an environment when interest rate risk has inflicted more pain.

Second, PIMCO Total Return has the lowest duration of the group at 3.99 years, but has lost more than the category average. The fund has been lighter in corporates than its peers – 19% versus 30%, according to Morningstar. It also has a significant allocation to what it classifies as “US Government Related,” which, according to PIMCO’s website, could include “nominal and inflation-protected Treasuries, Treasury futures and options, agencies, FDIC-guaranteed and government-guaranteed corporate securities, and interest-rate swaps.” Morningstar has its Agency MBS Pass-Through allocation at 39%, relative to 22% for its peer average. The fund’s most recent quarterly commentary mentions that positions in Agency MBS along with short exposure to the Japanese Yen, short exposure to duration in Japan and Canada, and exposure to high yield corporates” detracted from performance. The fund’s most recent monthly commentary lists non-U.S. rate strategies, positions in non-Agency MBS, and high yield corporates as the largest detractors.

It should be said that the new managers of PIMCO Total Return have done quite well since taking over in the fall of 2014. The new management team has been running the fund for a little over three years now, and, after a choppy start, the fund ranks in the 28th percentile of Morningstar’s intermediate term category for the three-year period ending in April 2018. A quarter’s worth of underperformance shouldn’t discourage any investor from choosing a particular fund or manager, though it’s useful to check in on asset classes and particular funds from time to time.

PIMCO: “New Neutral” Mostly Intact

It’s hard for one of the biggest bond managers in the world to forecast a recession when financial conditions are as favorable as they are now. Still, PIMCO isn’t sure if the global economy is being propelled by the “sugar rush” of easy financial conditions. The firm’s global Economic Advisor and Chief Investment Officer of Global Fixed Income, Joachim Fels and Andrew Balls, respectively, write in a new paper that their base case hypothesis remains that the global economic expansion is demand-driven, but they have “considerable uncertainty around this key question.”

Fels and Balls report that the bond behemoth in Newport Beach, Calif. now forecasts modestly higher 2018 GDP growth than it did at the end of 2017 in the U.S., eurozone, the U.K., and China. However, it has lowered its expectations for Mexico and India. Overall, the global forecast for growth remains in the 3.0%-3.5% range.

PIMCO concedes that their forecasts are baked into asset prices. In other words any disappointment on growth or inflation estimates would spell bad news for portfolios, so the firm remains conservatively positioned.

PIMCO views the U.S. Government’s infrastructure plan as having a “low probability” of passing through Congress anytime soon. The firm’s municipal bond team offered that contribution from the states to such a plan would be limited given “lack of fiscal space in many state coffers.”

On trade policy, PIMCO expects the tariff proposals on steel and aluminum to be “watered down further” beyond the exemptions already given to Canada and Mexico. Retaliation by Europe and others should also be limited. Neither would broader protectionist action against China regarding intellectual property spark an aggressive response.

On emerging markets, the firm remains mildly optimistic, but is aware of growth slowing due to deteriorating demographics, political risks, and protectionist sentiment.

 

New Neutral Intact?

Immediately following the financial crisis, PIMCO propounded a “New Normal” or “New Neutral” thesis arguing (correctly) that subsequent growth would be tepid and interest rates would be low. The firm relied on an influential book from economists Ken Rogoff and Carmen Reinhart called This Time It’s Different, a historical examination of debt crises that claimed past crises tended to slow future growth until the debt was worked off.

Currently, the firm thinks the thesis is intact because of all the debt that’s still accumulated and the need for economies to keep rates low in order to maintain growth. But PIMCO is slightly less certain about its view that rates must remain as low as they’ve been. Demographics influencing the new normal have not changed, however, and the firm doesn’t think tax cuts in the U.S will spur meaningful long-term growth. Fels and Balls write that while there is some risk to rising yields, “we do not think that we are at the start of a secular bear market for bonds.” The authors add that there is a good chance that there will be a recession over the next 3-5 years, and that there will be “limited capacity for conventional monetary policy, compared with historical experience” at that time.

 

Investment Implications And Portfolio Positioning

As a consequence of this analysis, PIMCO is avoiding big macroeconomic bets currently. The firm maintains “modest duration underweights,” including in Japan. The firm is also mildly overweight in TIPS. PIMCO tends to avoid generic corporate bonds, and gets its corporate exposure from short-dated structured products. The firm also likes some non-agency mortgages currently. The firm prefers to get exposure to emerging markets through currencies rather through bonds at the moment. Currencies are “the best way to express a positive view on EM fundamentals and to generate income.” PIMCO is neutral on U.S. stocks, but likes Japan, as it anticipates earnings growth there. Finally, the firm is modestly overweight in commodities – especially energy and base metals — “due to their stand-alone return prospects and their potential diversification benefits should the global economy accelerate, elevating realized inflation.”

 

Outlook for Major Economies

For the U.S., PIMCO expects above-trend real GDP growth in the 2.25% to 2.75% range in 2018. Low unemployment should continue, putting some pressure on wage growth and consumer price inflation. The Fed will gradually push rates higher under new leadership, making progress toward the 2% objective.

Growth momentum is strong and financial conditions are favorable in the eurozone. GDP growth should be between 2.25% and 2.75% for the year. The eurozone recovery is now broader than it has been in the past. Inflation and wage pressure are down, however, because of remaining labor slack and “persistent competitiveness gaps among member states.” PIMCO doesn’t anticipate a rate hike from the ECB until mid-2019.

In the U.K., PIMCO expects 1.5%-2% real GDP growth in 2018. Growth should pick up with progress toward separation from the EU. The Bank of England should hike rates twice unless Brexit talks break down.

PIMCO’s base case for Japan is a continuation of growth in a 1%-1.5% range. With an unemployment rate below 3%, wage growth should pick up, helping core inflation to rise to slightly below 1%.

Finally, PIMCO expects a “controlled deceleration” of China’s GDP growth toward around 6%-7%. Inflation should accelerate on a core basis and from higher oil prices. This should encourage the People’s Bank of China to hike rates. PIMCO is neutral on China’s currency, and expects China to control capital flows to damp exchange rate volatility.