Friday, November 20, 2009

What's Inside Pimco?

Pimco Total Return Fund is the world's biggest mutual fund. What's in its portfolio?

Pimco Total Return Fund's (PTTRX) nearly $193 billion in total assets rival the gross domestic product of a small country—of Chile, Singapore, or the Philippines, say. It is the largest mutual fund ever, dwarfing its closest competitor, American Funds' Growth Fund of America (AGTHX), which has $145 billion.

Despite manager Bill Gross' high-profile media presence and sage counsel on macroeconomic trends, the inner workings of his biggest fund remain largely a mystery. He has made public statements about favoring plain-vanilla mortgage bonds and, more recently, Treasury bonds, but his portfolio is complex. At 368 pages, the bond fund's June 30 report of its holdings is so opaque that many investment advisers have trouble understanding it. Many don't even try. "I don't look too much at what's in there," says financial planner Ray LeVitre of Net Worth Advisory Group in Midvale, Utah, which has upwards of $5 million in the fund. "That's why we hire Bill Gross—to take care of what's in there."

But what is in there? Gross was not available to talk about the fund. A snapshot of Total Return's portfolio doesn't help much. What Pimco considers cash, Morningstar counts as bonds, so the portfolio is leveraged from the fund tracker's perspective. As of June 30, it listed 131.3% of the fund's assets as bonds. An additional 58% was cash on the long, or positive, side of its balance sheet. And 94.6% was in cash on the negative or short side—a short sale being an investment that profits when prices fall. About 8% was in "Other," which at Morningstar can include convertible bonds, preferred shares, or derivatives. Such a portfolio, as described, would be akin to a leveraged hedge fund's.


Pimco Total Return is no hedge fund, but it does use some hedge fund techniques. "Leverage light is a hallmark Pimco tool," says Eric Jacobson, Morningstar's director of fixed income research. But "the people at Pimco call it 'bonds plus.'" It generally involves derivatives: The fund buys futures contracts or other derivatives to get exposure to bonds instead of buying bonds directly. It puts down a fraction of the full value of the futures contract, or what is called "notional value," as collateral. A contract providing $100 million in exposure to, say, mortgage bonds, might require only $5 million in margin collateral, creating a leveraged bet.

To counteract that leverage, a manager could put the $95 million difference in Treasury bills. That would create what's called a "synthetic bond," since T-bills are considered risk-free and so neutralize the effects of leverage. But Gross often buys other bonds. More than 100 pages of the holdings report are devoted to "net cash equivalents," a vast array of debt ranging from mortgage bonds to emerging-market debt. The bonds are labeled cash because they have durations of less than one year. Duration is a wonky term that signifies how sensitive a bond's value is to moves in interest rates. If a bond fund's duration is 1.5 years, it means the fund will decrease about 1.5% in value if interest rates rise 1%, and it will increase 1.5% if rates fall by the same amount. For Pimco, anything with a duration of less than 1.0 and a high credit rating is a "cash equivalent."

According to Jacobson, Morningstar uses a different and more restrictive definition of cash than Pimco. To be labeled cash in Morningstar's terms, bonds must have maturities (not just durations) of less than one year. Many of the bonds in Gross's cash-equivalent section have maturities several years out. Thus, to Morningstar, the fund is leveraged in bonds—that earlier 131% figure—though Pimco would call that extra 31% cash. Either way, Jacobson feels Gross has managed risks effectively. "Pimco does well investing in these bonds with a little longer maturities than cash to pick up a few extra [decimal] points in return," he says. And the 94.6% negative, or "short," cash position in the Morningstar report is cash Pimco theoretically owes on its derivative contracts as collateral if you calculate their full notional value. It is not really a short position.

Although the Total Return Fund's leverage is mild and common among bond funds, there are risks. Manager Jeffrey Gundlach of the $11 billion TCW Total Return Fund (TGLMX) won't buy derivatives. "Many bond funds blew up last year that used derivative contracts, because instead of putting [collateral] money in T-bills, they invested in asset-backed securities they thought were the same as cash," he says. "Some of those securities fell more than 50%. Funds suffered massive losses because they were trying to goose returns by a few [decimal] points."

Gross, however, bested 95% of his peers over the past decade. (The percentage rises to 98% for the low-cost institutional share class.) The fund's derivative positions seem to have a big influence on performance. As of Sept. 30, a third of the fund's "duration exposure" was achieved through derivatives. Says Jacobson: "For the average manager, Pimco's level of derivative use would make me very concerned. What separates Pimco and Bill Gross is a demonstrated long-term track record of being really good at this type of investing."

Financial advisers tend to echo those sentiments. "I don't look at bond fund holdings but at how funds perform in different market conditions," says financial planner Jeff Feldman of Rochester Financial Services. "Derivatives are beyond my understanding, but if this fund were heavily leveraged, it would be more volatile than the average bond fund. But it isn't."

Of course, a basic axiom of investing is "know what you own." So what does it mean that the largest mutual fund in American history is tough to figure out? The fact is, no one seems to care as long as the performance is good.

With Tara Kalwarski

Braham is a freelance writer in Brooklyn, N.Y.

(from, November 20, 2009)

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