News, Vision & Voice for the Advisory Community
The PIMCO founder is a mutual fund manager and may view the market with a trader's eye
July 25, 2011 — 2:14 PM UTC by Brent Burns
Brooke’s Note: Bill Gross stands atop a mountain in the investment industry that makes him the most heavily quoted and least-questioned source of information about the bonds, interest rates and even the economy in general. There are good reasons his words are viewed as gospel. The 67-year-old founded Pacific Investment Management Company of Newport Beach, Calif. in 1971, and he now oversees nearly $1 trillion of assets including management of about $250 billion in the Total Return Fund. His performance has been consistently good because he knows what he’s doing. But such heavy reliance on a single source of information seems questionable for financial advisors. RIABiz has been looking around for someone with the knowledge of bonds and of Bill Gross himself to serve as a reality check on the river of opinions that flows from him. Brent Burns, (See his full bio at the end of this column) after some convincing, has agreed to play that role. He is a principal of Asset Dedication LLC of Mill Valley, Calif. and manages bond portfolios as separate accounts on behalf of financial advisors.
The investing world is not absolute. Different perspectives often lead to different conclusions. However, I have found a generally lopsided view of bond investing where the perspective of bond fund managers dominates the financial media. PIMCO’s voice in particular, perhaps in direct proportion to its dominant market position, dominates the information flow about bond investing. Like investing, diversification of investment perspectives can help reduce risk. With that in mind, I have been asked to occasionally provide a contrarian perspective on PIMCO’s comments. See: See: Why PIMCO’s brand is most sterling and Powershares, Vanguard and ProShares are fast-gaining.
Bill Gross, the world’s largest bond manager, has certainly earned his status as a go-to spokesperson for bond investing and is a voice worth listening to on the bond market and the state of the economy in general. But it is also important to remember that he has a particular view on investing.
It is no secret that he takes a very active approach to portfolio management by taking bets on factors like credit spread and yield curve shifts. With a turnover ratio of 400%, more than double the average bond fund in its category, it is unlikely that a bond purchased in the PIMCO Total Return Fund (PTTRX) will be held for very long. So, in general, we need to note that he does not look at a bond as a long-term investment.
My purpose is not to provide commentary on PIMCO funds, which have been top performers for years. Neither is it to criticize their analysis of the bond market nor to call them out for missed calls. That would be unfair, because they often make the right call. My goal is to frame Mr. Gross’s commentary in the context of his approach to bond investing and provide a different perspective.
Bonds as a safe investment
So where am I coming from? I don’t believe that a client’s bond portfolio exists in a vacuum. I think that high quality bonds are supposed to be an investor’s safe assets. Given the lower rate of return for bonds relative to stocks, investors are not well compensated for taking on risks in their bond portfolio. Although an investor can go years without the risks being brought to the surface, a high-quality bond portfolio should be a source of stability when the rest of the portfolio is falling apart.
For investors who need equity exposure in their portfolio to increase their chances of reaching their goals, bonds should be the buttress that protects the portfolio when the equity markets appear to be crumbling. It is the bond exposure that gives investors fortitude to ride through the turmoil without succumbing to emotional pressure and selling their equities at just the wrong point and allows investors to realize the higher long-term expected return. Seeking marginal returns in the bond portfolio at the expense of safety can put the client’s bond portfolio on shakier ground.
Hunting for yield is not without risk
I have a different opinion from Gross when it comes to adding risk into a client’s bond portfolio to chase yield. Recently, at the 2011 Morningstar conference, Gross suggested that investors look for yield in ever more exotic places (Brazil and Germany) to achieve a higher return. See: Bill Gross wows advisors at Morningstar conference, but not with good news.
As part of a larger asset allocation strategy, adding political and currency risk for relatively small potential returns ignores the role that high-quality bonds ought to play in the client’s overall portfolio. These specific recommendations concern me because Brazil has a long history of defaulting on its sovereign bonds (three times in the last century) and Germany’s sovereign bonds have returned less than Treasuries this year. Trying to find a cross-border value play just doesn’t seem worth the risk.
PTTRX has a reputation of moving in and out of positions to take advantage of projections. Sometimes it works and sometimes – as with the recent short of Treasuries in advance of a rally, it doesn’t. The problem with an active strategy, like the short on Treasuries, is timing.
I don’t disagree that eventually a short position on Treasuries will pay off. At some point we will see yields rise and the position will pay off. The problem is that in the short run it adds risk to a portfolio and it could take years for that payoff to be realized. Remember, Alan Greenspan’s 1996 warning of “irrational exuberance” didn’t come true for another three years. Although this hunt for yield and return can add value when they make the right call, it also adds risk to the downside in a portfolio that ought to be seeking more stability.
Landing on your feet
Like most followers of the bond market, I think that the 30-year bull market for bonds is over. The period of declining rates that started in 1981 was a tremendous time to be investing in bonds. With current rates approaching historic lows, it is difficult to imagine that rates would continue fall much further. To me it sets up a paradigm shift that may reveal the status quo of bond fund investing to be out of date.
For 30 years, yields have fallen and prices have risen. Everyone has been a total return investor, even if it wasn’t their original intent, because it just didn’t make sense to hold a bond to maturity when you could harvest gains. Even with the hefty yields in the early 1980’s, the gains were simply too good to pass up. For example, the 10-year Treasury ended 1981 yielded almost 14%, but total return for the next year was 40%, which could only be recognized if you sold the bond. This was enough to entice even the most conservative coupon-clipping grandma to get in on the action.
97% of all taxable bond funds, including PIMCO Total Return, started after 1981 and have never experienced a sustained flat or rising interest rate environment. Bond fund managers’ investment philosophy and acumen has been shaped by a declining rate environment where an investor’s return is enhanced by turning over bonds, selling them before maturity to harvest the price increase.
But those days are gone. Bonds can no longer be viewed as a sluggish total return investment. When interest rates start to rise, turning over a bond portfolio will lead to realized losses and will require a different approach. This change in environment reminds me of how the shift to foam landing mats changed the playing filed for the high jump and made it possible for high-jumper Dick Fosbury, inventor of the “Fosbury Flop,” to win the Olympic gold medal in 1968 by landing on his back instead of his feet. Those who honed their skill landing in sawdust were left in the dust when they could not adapt to the new environment.
In a rising-rate environment, investors ought buy bonds with the intention of holding them to maturity. Although this will lock in relatively low yield to maturity, when rates rise the total return will still be positive so long as investors don’t sell early and realize the paper loss.
This approach, however, is not how PIMCO and the majority of bond fund managers look at the bonds in their portfolio. They are making bets on credit spread and interest rate moves. In a falling interest rate environment, rising prices can mask the added risk of taking bets, but the headwind of rising rates only magnifies them. My future commentary will show Gross’s comments in the light of his active approach to bond investing and provide a contrasting perspective of a conservative buy-and-hold investor since we view the purpose of bonds in a different way.
Brent Burns is president and a founding partner of Asset Dedication LLC a fixed income separate account manager. The firm’s origins reach back to an academic research project out of the University of San Francisco Graduate School of Business that started in the mid-1990’s. This project ultimately lead Brent and his firm’s co-founder Professor Stephen Huxley to write the book Asset Dedication: How to Grow Wealthy with the Next Generation of Asset Allocation (McGraw-Hill, 2005). Burns holds an MBA with honors from the University of San Francisco and a BS from the University of California, Berkeley. He is also a former world-class pole vaulter and member of the U.S. National Track and Field Team.
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