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Fund name: PIMCO Global Advantage Strategy Bond Fund, "D" class (PGSDX) (Update)

Objective: The fund tries to outperform a new global bond benchmark, the PIMCO Global Advantage Bond Index (how convenient). The fund does not engage in currency hedging and it offers exposure to the entire global debt market (sovereign and corporate, investment grade and junk, developed and developing). The fund and index try to distinguish themselves from the competition by focused on breadth of coverage and GDP-weightings rather than capitalization-weightings.

Adviser: PIMCO, a unit of the German financial services company Allianz. PIMCO is, most famously, a fixed-income shop and home of Bill Gross, the world’s leading bond investor. More broadly, they’re a leading global investment management firm with $800 billion in assets (9/30/08) and more than 1000 employees in offices in nine countries. They were founded in 1971 and manage separate accounts for phenomenally rich people (minimums range from $25 million - $75 million), 60 institutional mutual funds for the merely rich ($5 million minimum) with a bunch of investor-class shares (A, B, C, D and R) for us po’ folks.

Manager: Mohamed El-Erian and Ramin Toloui. Dr. El-Erian is a co-CEO and co-CIO of PIMCO. He joined PIMCO in 1999, and re-joined it in 2008 after serving for two years as president and CEO of Harvard Management Company, the group that manages Harvard’s endowment. He’s got a PhD in economics from Oxford and an undergraduate degree from Cambridge. (Show-off.) Mr. Toloui joined PIMCO in 2006 as a global economics and emerging markets specialist. He spent seven years working at a fairly high level for the International Division of the U.S. Department of the Treasury.

Management’s Stake in the Fund: None yet recorded. In general, PIMCO managers have little or nothing invested in their funds. On the upside, every board member has over $100,000 – generally way over $100,000 – invested in PIMCO funds.

Opening date: February 5, 2009.

Minimum investment: Varies by share class. The "D" class shares (PGSDX) commonly available in retirement plans have a $1000 minimum.

Expense ratio: 1.45% on assets of $3.1 million.

Comments: Bond managers are, by nature, a conservative bunch. They’re the sort of folks who know the importance of fiber in a balanced diet, and try hard to get their fiber through carefully-washed produce rather than supplements. They wear sensible shoes, keep the thermostats down a bit in winter and say things like, "there’s no shame in driving a 15-year-old car as long as you’re keeping up on the maintenance." At night, they dream of income statements.

It’s no real surprise then that most bond indexes, and the funds that stay close to them, are conservatively constructed. They prefer sovereign debt over corporate. They prefer US over foreign, developed over developing, investment grade over speculative. Those preferences are, in sum, for what has reliably worked before.

In general, that’s a sound strategy because, in general, it has worked to provide a reliable cash stream to investors more interested in income than appreciation. Here’s the fear: what happens if the game changes? What happens if the old reliable debt issuers – primarily the U.S. Treasury – are no longer the best places to invest? What if, as Dr. El-Erian and PIMCO believe, there is "a rapidly changing fixed income universe" with "dramatic transformations in growth drivers, wealth dynamics and institutional arrangements"? In short, "a new environment" for income investors?

PIMCO argues that periods of change require forward-looking rather than backward-looking strategies. Traditional bond benchmarks are backward looking because they’re weighted on market capitalization. Like the price-weighted equity indexes, they give the most weight to issuers based on dollar volume rather than on any intrinsic merit. If the U.S. government is the world’s largest issuer of debt, then it gets the top spot in bond benchmarks just as ExxonMobil gets the top spot in the S&P500 because their stock is . . . perhaps, the most overvalued? In stock investing, PIMCO relies on the services of Research Affiliates whose "fundamental indexes" are weighted toward underlying economics rather than simple market valuations. In the long term, strong underlying fundamentals should drive above-average market returns. That is, they’re forward looking. In bond investing, PIMCO appears to be trying to capitalize on the same dynamic by weighting its bond index by GDP rather than past debt issuance.

Two consequences flow from that decision. First, they’re hoping to invest in countries and companies with the best growth prospects. Such countries should see currency appreciation and, eventually, heightened interest from more traditional bond investors. Both of those factors might contribute a degree of capital appreciation to the PIMCO fund. Second, they believe that their index will be "counter-cyclically rebalanced". Bond prices, they say, move inverse to GDP growth. As a result, countries with rapidly growing GDPs have falling bond prices. PIMCO will then be buying larger numbers of shares at lower prices.

Beyond that, PIMCO argues that the fund’s broad mandate will offer both diversification and yield benefits. They describe their investment universe as covering "the widest possible variety of fixed-income investments" from "developed to emerging markets, nominal to real assets and cash to derivative instruments." As of 12/31/08, the benchmark index would include:

21% securitized bonds

20.9% corporate bonds

20.8% interest rate swaps

10.1% inflation-protected securities

9.3% international bonds denominated in various currencies

9.0% fixed-rate government bonds

8.9% currencies

By way of currency exposure, it’s 34% US dollar, 26% Euro, 10% Yen, 18% emerging markets and 12% "other industrialized." Since some emerging market bonds are priced in other currencies, such as the US Dollar, actual exposure to those markets is substantially higher than just currency exposure implies: as of February 2009, 27.9% of the benchmark index would be invested between 28 emerging market nations. By contrast, Vanguard’s Total Bond Market Index (VBMFX) fund has 33% U.S. government bonds, and only 5.3% international exposure and 15.8% corporates, with no inflation-protected corporate bonds in the mix.

Bottom Line: This is PIMCO’s core competence. By Morningstar’s reckoning, only four of PIMCO’s bond funds are below-average performers while a third of them earn Morningstar’s highest rating. That’s impressive because the funds tend to receive average to above-average risk ratings. And the logic is compelling.

Potential investors need to keep two limitations in mind. First, there’s no publicly-available risk/return profile for the index or the fund. Second, because the fund is actively managed, it doesn’t attempt to replicate the index. It attempts to outperform it "consistent with prudent investment management." While PIMCO’s management is consistently "prudent," potential investors need to remember that that’s not the same as "cautious, conservative."

Fund website: PIMCO Global Advantage Strategy Bond Fund. Folks interested in examining the construction of the benchmark Global Advantage Strategy Index can find the documents here.

March 1, 2009

Update (July 1, 2010):

Assets: $1.8 billion Expenses: 1.1%
YTD return (through 6/17/10): (0.7%)

Our original thesis: This is PIMCO’s core competence. . . and the logic is compelling. That said, there’s no publicly-available risk/return profile for the fund and it’s not clear how much risk PIMCO will court to avoid the risks posed by a major meltdown.

Our revised thesis: Makes sense, but it hasn’t worked yet. Maybe that’s a good thing?

Bond investors increasingly suspect that the charming scoundrel, Professor Harold Hill, was right:

Well, either you're closing your eyes

To a situation you don't wish to acknowledge

Or you are not aware of the caliber of disaster indicated

By the presence of a mindless buying in your community.

Ya got trouble, my friend, right here,

I say, trouble right here in Investor City.

Since the start of 2009, investors have dumped about a half trillion additional dollars into bond funds. Since the beginning of the financial crisis in 2007, the index of 10-year government bonds has returned 30% or so. You can divide price by yield to get a measure of how pricey those bonds have gotten, about the same way you divide price by earnings to express a stock’s valuation in its price/earnings (p/e) ratio. Those bonds are now selling at the equivalent of a 30 p/e, around twice their historical level. That reason for all that is simple: people are frightened about stocks and, for the past 30 years, the decision to buy bonds has been a nearly riskless way to make – or, at least, not lose—money. Investors forget that the 30 year bull market in bonds was preceded by a 38 year bear market (1948-1980) for them.

Those developments are making professional investors nervous. Steve Leuthold, mastermind of Leuthold-Weeden and the Leuthold Funds, is shorting Treasuries and selling his long-term high-yield stake because "there's probably as much risk in bonds as there is in stocks now." Chris Davis of the Davis Funds, speaking in late May, said "the only real bubble in the world is bonds. ... When you look out over a 10-year period, people are going to get killed." Probably within the next couple years. "The bond market is a bubble," says Robert Froehlich, senior managing director of the Hartford Financial Services Group. "And it's getting ready to burst." Marilyn Cohen, author of The Bond Bible, argues that "Any time you see a single asset class so overwhelmed by cash . . . eventually the luster will wear off, or some type of event will happen, and then it will be a mass exodus out. It cannot have a happy ending."

Income-seeking investors have three alternate paths: (1) short the bond market, as Leuthold is doing; (2) look elsewhere – to convertibles, master limited partnerships, high dividend stocks – for income; or (3) stick with bonds but try to out-think the problem.

PIMCO Global Advantage follows the third strategy. It has a custom benchmark index which targets bonds from credit-worthy borrowers, while most bond indexes simply overweight the most profligate borrowers. This is an actively-managed fund that can invest in a wide array of securities, the benchmark index helps discipline the process by directing the managers’ toward the most reasonably-valued locales. In theory, they’ll at least dodge the worst of any global bond crisis and, at best, might profit from a "flight to quality" reaction when other investors bid up the bonds of more credit-worthy nations.

Nice idea and nearly $2 billion dollars worth of investors have bought the story so far, a tremendous amount for a fund that’s barely a year old. Unfortunately, the strategy hasn’t yet paid off. The fund has modestly trailed its average world bond peer since inception with a return of 14% to its peers’ 17% (02/09 – late 06/10). The fund also trailed the average world bond fund during the May mini-crash, which was of course precipitated by the sorts of concerns that the fund was designed to address.

PIMCO is the Big Dog in bond investing. They have made a considerable commitment lately to rethinking how folks approach investing, and fixed income investing in particular. They are more likely right than wrong in their diagnosis. Despite the fact that the fund’s expenses are high for a bond fund, there’s no reason to avoid investing here. They just haven’t yet provided any compelling reason yet for actively seeking it out.



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