Pimco's Flagship Mutual Fund Trails the New ETF

NEW YORK (TheStreet) -- With $263 billion in assets, the Pimco Total Return Fund (PTTRX) ranks as the world's largest mutual fund. Over the years, investors and journalists have often asked portfolio manager Bill Gross the same question: Is the fund too big to manage effectively?

Gross argued that size was not a problem for the fund. There seemed little reason to doubt the Pimco manager because he delivered sterling returns. During the past 15 years, the fund returned 7.4% annually, outdoing 98% of intermediate-term competitors, according to Morningstar.

But now there is evidence that size has slowed down the fund. In March, Gross started Pimco Total Return ETF (BOND), designed to resemble the flagship mutual fund.

Since it started the new ETF has returned 7.5%, compared to 3.8% for the mutual fund. Analysts argue that the reason for the outperformance is size. The ETF started with $100 million in assets and now has $2 billion. "The ETF can trade more nimbly," says Paul Baiocchi, an ETF analyst for IndexUniverse.com.

Academic researchers have long found that big stock funds trail small ones. To appreciate why, consider a stock fund with $10 billion in assets. Suppose the portfolio manager wants to put 3% of assets, or $300 million, into one stock. To accomplish the trade, the manager may have to spend days assembling the shares.

Because the trade takes so long, it is harder for the manager to capitalize on bargains. As he tries to make purchases, his bids could push up the stock price and erode the fund's returns. In contrast, a fund with $100 million in assets could assemble a 3% position in seconds.

Gross has long argued that his bond fund is different from the stock portfolios examined by the academics. The Pimco fund often trades large quantities of liquid securities such as Treasuries. Because it generates so much volume, the Pimco trading desk can get bargain prices on giant purchases, Gross says.

But analysts argue that Pimco mutual fund is unwieldy compared to the ETF. While the mutual fund holds 18,000 securities, the ETF only has 300. To fill the enormous mutual fund, Gross must inevitably buy some bonds that are not his very favorite issues. In contrast, he is free to only put his best ideas into the ETF.

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