Pimco’s launch in the US of an ETF version of its Total Return Fund is attracting a lot of interest. But the firm faces formidable challenges in delivering the positive total return it promises.
The new ETF, called TRXT, has the objective of seeking the maximum total return that is consistent with capital preservation and prudent investment management.
In its marketing literature, Pimco says that while “many bond portfolios focus solely on yield...bonds may also provide capital gains. The return calculation that takes into account both interest income and capital gains is known as total return. Pimco’s Total Return portfolios are best described as a core bond strategy that seeks to maximise price appreciation and current income with index-like volatility”.
This all sounds well and good. The problem is that bonds are surely in the final stage of a 30-year bull market, during which long-term US Treasury yields have fallen from over 15 percent to the current 3 percent. At shorter maturities, yields are now close to zero in many developed markets, making further capital gains a mathematical impossibility (ignoring the twilight zone of negative interest rates) and offering nothing in interest income. Finally, under quantitative easing programmes, bond prices are being heavily supported by central bank intervention, a story that usually ends in tears (and with the price of the supported asset plummeting).
Last spring’s “will he, won’t he” flip-flopping over US Treasury exposure by Bill Gross, manager of TRXT and also of the US$250 billion Pimco Total Return fund, signalled understandable discomfort at having to invest at such low yields. To his credit, Gross soon went on record as saying he’d made a mistake, but a year later he and other bond fund managers still face basically the same uncomfortable choice: go along with the QE-inspired bond support scheme and gather a meagre return from interest income, or take on the world’s central banks and go short.
Except that you can’t take a negative view on bonds with this ETF, and there’s the problem. While the original Pimco Total Return fund can use interest rate swaps and credit derivatives to manage risk and hedge against rate rises to some extent, TRXT is unable to do so as a result of the current SEC embargo on using derivatives in ETFs. Another mutual fund in the Pimco range, the Unconstrained Bond Fund, can even go to a position of negative duration, profiting from potential rises in bond yields.
So while TRXT is constrained to staying “long” the bond market, it may well struggle to provide the positive returns it promises, however much skill its manager can exhibit.
In Europe, where the use of derivatives in an ETF structure is permitted, so far there are no actively managed ETFs allowing investors to profit from potential interest rate rises (although there are quite a few inverse bond ETFs, giving formulaic exposure to indices that gain when bond prices fall). Pimco’s existing five European ETFs, all managed on the Source platform, are either index trackers or actively managed money market funds with a cash-plus target.
Could a low-cost active fund that can short bonds be the next big winner in Europe’s ETF market?