One of the more popular corners of the actively-managed ETF landscape has been in the bond category where several new funds have managed to amass a great deal of assets in a short period of time. Investors have likely embraced active management in this slice of the market thanks to perception that bonds are still an asset class that active management can add value in due in large part to the large size of the market and the relative illiquidity of most securities. With that being said, most ‘superstar’ bond managers have abstained from launching products in the space preferring to instead remain in the mutual fund or CEF world. However, this could soon change as PIMCO recently filed for an ETF version of its Total Return Fund, the most popular bond fund in the world by assets under management.
In order to get a better handle of what this means for the ETF world, I recently read a great paper from Todd Rosenbluth, a Senior Director at Standard & Poor’s U.S. Equity Research. In his paper, Todd outlined the projected impact of this product on the marketplace and how it could make waves in the ETF industry. I recently interviewed Todd to get more of his thoughts on both the PIMCO Total Return ETF and how this fund may differ from its already well-established mutual fund counterpart:
ETF Database (ETFdb): First off, for the readers out there that may not be aware, why is the proposed PIMCO Total Return ETF such an important development for the ETF industry?
Todd Rosenbluth (TR): There are a couple of reasons for why this is significant to us. One, PIMCO Total Return, the mutual fund, is the largest taxable bond fund, and money has continued to flow into this product in recent years. PIMCO Total Return, the institutional share class, has over $140 billion tied to it. It is one of the best performing taxable bond mutual funds that we, S&P Equity Research, have data on. It also has a track record, both short and long, of success which is tied with manager Bill Gross and has relatively low interest-rate sensitivity. These are all positives to us. Second, most ETF assets still remained tied to passive indexes like the S&P 500, or the Russell 3000. Active management is still a rather small part of the marketplace. So PIMCO Total Return with its brand name could excite people who aren’t sure if they want to be in the active ETF game or want to stick with what they have been doing [also see Talking Actively-Managed ETFs With Tom Graves].
ETFdb: The PIMCO Total Return bond fund uses a lot of derivatives in its process, correct?
TR: Yes, that is correct. It is unclear to us how big of a factor it is in contributing to the overall performance because it is hard to slice and dice whether derivatives were substantial or just part of the strategy that is there. But when we look at the underlying holdings of PIMCO Total Return, or the top ten holdings, you see lots of derivatives there. The fund’s asset allocation includes derivatives in addition to investments in government and corporate bonds that investors are more aware of.
ETFdb: Is it true that the SEC will not allow this ETF to use derivatives, or do you think that this may change in the near future?
TR: Correct. About a year ago, the SEC began a review of how mutual funds and ETFs are making use of derivatives, and there is a concern that we feel from the SEC and other regulators as to the transparency and the risk characteristics of using derivatives in packaged products. So currently no, they are not allowing new ETFs to invest using derivatives. Until PIMCO Total Return is launched, it will fall under that same jurisdiction. It is conceivable that the SEC wraps up its review, but they have been quiet for much of the last 12 months on the topic. If PIMCO Total Return the ETF, which will have the symbol TRXT, was launched tomorrow, it would not be able to use derivatives, and this could have an impact on how successful the ETF is, or how identical a track record could be versus the more traditional mutual fund [ETFs vs. Mutual Funds: The Ultimate Guide].
ETFdb: PIMCO generally reveals its moves for the mutual fund on a monthly basis and it is usually a big deal, as Bill Gross will come out and give a lengthy discussion about the changes to the portfolio. But the ETF will have to follow a daily disclosure requirement. Do you think that this will impact the ETF or will it really not have a major impact on the product at all?
TR: That, I think is an important question that is hard to answer. Because we don’t know what happens intramonth with the mutual fund, it is not clear if there is a gradual process to asset allocations, or if there is a more radical or significant change when they alter their exposure. So it is unclear, if it is a slow turning of the ship, then we probably won’t see much change and people probably won’t notice what is happening, but if it is a more significant process, where on one day they make bigger moves, we would see it as it happened. To give a caveat for how large the PIMCO Total Return is, it is more likely that they are making gradual shifts and probably not making big moves on one day in particular. With mutual funds we tend to see more gradual shifting of the portfolio. That daily disclosure aspect is something that, we believe, has reduced the number of actively managed ETFs in the marketplace because managers don’t want to show all of their cards. They want to be able to keep their practices internal and limit the disclosures they have to a quarterly basis so they can make the changes that are in the best interest of their investors and not worry about the market reacting to their moves.
ETFdb: In terms of expenses, how do the proposed fees for TRXT compare to the mutual fund counterpart of the PIMCO Total Return fund?
TR: Let me start with the premise that we at S&P think that understanding how much your mutual fund or ETF costs should not be the only deciding factor between choosing one ETF or mutual fund over another, but it is an important factor that should be a part of the process. The regulatory filings showed that TRXT will have an expense ratio of 55 basis points. That is less expensive than the mutual fund PIMCO Total Return (PTTAX) which is currently charging an expense ratio of 91 basis points. But while the 55 basis points is much lower than the mutual fund’s expenses, this figure is still higher than a number of the widely owned and held fixed income ETFs that are in the marketplace. Let me offer a couple of examples. TIP charges 20 basis points; BIV has an expense ratio of just 11 basis points. So in order for PIMCO to do well gathering assets as an ETF, investors will have to believe that active management is going to make the difference, and want to pay double or significantly more than what they are currently paying for their current taxable fixed income ETF [see Five ETFs To Be Excited For].
ETFdb: Do you think that will be the case? Do you think people will see the value in partnering up with this PIMCO ETF for their holdings or do you think people will stay with the more traditional or cheaper ETFs?
TR: We think it could do very well. There is a lot of money flowing into fixed income assets, whether it is going towards mutual funds or ETFs. We think that a new product with a strong brand and a strong track record that people are familiar with on the mutual fund side will likely make some investors turn their heads and look more closely at it. It will then be up to the investor to decide if they want to pay more money for active management. We think some people are going to say yes to that, so there are going to be investors allocating to some of the widely held fixed income ETFs that are likely to look towards TRXT when it comes out and see if it is worth paying attention to.
In addition, the PIMCO Total Return mutual fund that is more expensive than the ETF could possibly lose some assets to the ETF as well because the exchange traded product will be less expensive and more liquid. Someone who wants to get in or out of an ETF faster could look to do so without having to pay a sales charge or other expenses that are tied to mutual funds. Because of the brand and the track record that the mutual fund has established, we think that people are going to take a look. When it comes out, we will take a look at it and get a better understanding as to the characteristics of the ETF and like a mutual fund, we think the investors should pay attention to the volatility, the credit rating and the duration of the underlying holdings; all of these things are important when analyzing a mutual fund and are also important when looking at an ETF.
ETFdb: Will the ETF be able to use the recent return of the PIMCO mutual fund when advertising for themselves, or is that not allowed?
TR: I think no. I think they will have to market themselves as a stand-alone product and if they will refer to the track record of the mutual fund, but will have to disclose that it is a different product. When it ends up on our MarketScope Advisor system, because it is not currently ranked, we will treat it as a standalone offering and not refer to the mutual fund that we have a ranking on, but we expect people to take a look at the mutual fund for perspective. When PIMCO or other mutual fund companies launch a new offering with the same manager, people can look to that as a guide. But because this will be different as to the derivatives and daily disclosure, it would be hard to compare the mutual fund and the ETF and say they are going to be identical [also see the Mutual Fund To ETF Converter].
-All of Todd’s reports, including his one on PIMCO’s Total Return ETFs, can be read on the Standard & Poor’s MarketScope Advisor website. Access does require registration though.
Disclosure: No positions at time of writing.