An Impressive First Year for Bill Gross's ETF

Investors who were prescient enough to buy the actively managed exchange-traded fund run by Bill Gross have been rewarded handsomely. Pimco Total Return Exchange-Traded Fund (symbol BOND), which will turn one year old on March 1, has been on a tear.

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The ETF, which Gross runs in the same fashion he manages his firm's flagship — the Pimco Total Return mutual fund (PTTDX — returned 12.2.% from its inception through February 14. Over that period, it whipped its benchmark, the Barclays U.S. Aggregate Bond index, by a whopping ten percentage points. And it beat its mutual fund cousin by five points. The ETF has already gathered $4.1 billion in assets. The mutual fund, the world's largest, holds $286 billion.

Gross says he's particularly proud of the ETF's record because it was accomplished without the heavy use of derivatives (instruments that derive their performance from the performance of other investments). "We're glad to have BOND around because it proves that derivatives aren't the secret to Pimco's secret sauce," he says. Unlike the traditional mutual fund, the ETF can't use derivatives because of a Securities and Exchange Commission ban on the use of these instruments by new actively managed ETFs that was in place at the fund's inception. The SEC lifted that ban in December, so Gross will be able to employ derivatives in the ETF as soon as the fund's board of directors grants approval for their use, a move that could occur within a few weeks, says Gross.

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Even so, he doesn't anticipate making big use of the stuff once he gets the go-ahead. "Pimco is becoming less and less of a derivatives firm," Gross says. "Not because we've been chastened but because there's no high-grade octane in most derivatives anymore." He says that futures contracts, which represent bets on the future price of something, currently account for 2% of assets in the mutual fund version of Pimco Total Return, compared with a historical range of 20% to 25%. And swaps currently account for 1%, compared with a historical range of 10% to 15% (swaps represent a promise to pay something in exchange for something else, such as a promise to pay a fixed rate and receive an adjustable rate). Gross dismisses the notion that he has come to rely more heavily on derivatives because of the ballooning asset base of the flagship Pimco Total Return fund.

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Yet the lack of derivatives accounts for little of the performance gap between the ETF and the traditional fund. That has more to do with the fact that the ETF doesn't have the large legacy positions that the older fund does, and it has been building its portfolio from scratch. For example, the ETF holds 22% in Treasuries and U.S. government agency debt, compared with 34% for the mutual fund. And the ETF holds 10% in municipal bonds, compared with the traditional fund's 5% stake in munis.

Like the flagship fund, Total Return ETF is restricted in the extent to which it can make interest-rate bets. Specifically, Gross must keep the ETF's duration (a measure of interest-rate sensitivity) within two years of the fund's benchmark, the Barclay's U.S. Aggregate index (duration represents how much a particular bond or fund would be expected to rise or fall in price, given a one percentage point change in interest rates). The ETF's current duration of 4.7 years implies that it would lose 4.7% in price if interest rates rise by one percentage point. The current duration of the Barclays index is 5.2 years.

Gross insists that he isn't powerless to protect the ETF from rising interest rates. He says that if he expected interest rates to rise, he could lower the fund's duration to the minimum allowed, invest more in foreign bonds and buy Treasury inflation-protected securities. Even if there's a bear market in certain U.S. bonds, he says, "there wouldn't necessarily be a bear market everywhere." Ten-year Treasuries currently yield 2.0%, up from the all-time low yield of 1.4%, set in July.

Gross believes that as long as the economy remains sluggish and inflation expectations remain low, long-term interest rates will remain low as well (short-term interest rates are controlled by the Federal Reserve, which has vowed to keep short-term rates at zero until the unemployment rate drops to 6.5%). Gross expects that to be the case for at least the next six to 12 months. "And that doesn't mean a bear market. That just means returns are much lower than bond investors are used to," Gross says. He says investors should expect to earn the fund's yield over the next year, but they shouldn't expect the kind of strong price gains that the fund delivered over the past year. He says the ETF will likely generate a return of about 3.5% over the coming year. The fund's 30-day SEC yield is currently 2.2%.

Longer term, however, he does see rates eventually rising. "The outlook for bonds is really the outlook for inflation," Gross says. He says investors should watch for the U.S. inflation rate to rise to 2.5% to 3% annualized, and for the unemployment rate to fall, as the best signals of when interest rates will rise. The U.S. inflation rate was 1.7% for the past year through December. Says Gross: "Those are the two things that investors should keep their eyes on to know if bonds can be successfully clipped for their coupons or if we're entering a bear market."

Pimco's annual expense ratio of 0.55% is high for an ETF. That shouldn't be surprising considering that most ETFs aren't managed in the traditional sense and simply try to track an index. But BOND's fees are less than the 0.75% per year charged by no-load D shares of the traditional mutual fund.