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How Bill Gross Topped the S&P 500

You might think that any bond manager should be able to top money-market rates. In fact, the strategy is extremely difficult to execute. Gross comes up short some years, and competitors have done worse.

Since the financial crisis, PIMCO StocksPLUS has generally topped the benchmarks. In 2012, the fund returned 21.1%, outperforming the S&P 500 by 5 percentage points and surpassing 96% of large blend funds.

Gross scored gains by emphasizing corporate bonds and lower-quality mortgages. Those outperformed money markets by a wide margin. The fund trailed the benchmark for a three-year period starting in 2004. During those years, maintaining futures positions cost around 5%, and it was relatively hard for bond managers to compensate for the steep expenses.

If interest rates rise in coming years, as many economists expect, then the PIMCO funds could face harder times. When rates climb, bond prices tend to fall. But Gross has enough tools to continue topping his benchmarks.

PIMCO StocksPLUS Absolute Return is allowed to sell bonds short, profiting from falls in prices. PIMCO StocksPLUS is not permitted to short. But it has the freedom to buy high-yield bonds and other issues that sometimes rise during times of climbing interest rates.

PIMCO Fundamental IndexPLUS ranks as one of the company's most notable funds. While most of the PIMCO IndexPLUS funds seek to outdo common benchmarks such as the S&P 500, the fundamental fund aims to top the Enhanced RAFI 1000 index. Designed by Research Affiliates, the RAFI benchmark weighs stocks according to fundamental measures such as sales and dividends.

Under the RAFI system, companies with large sales have a bigger impact on the benchmark. That is very different from standard benchmarks, which weight stocks according to their market values. Apple (AAPL - Get Report) has the heaviest weight in the S&P 500 because the stock is the largest according to market capitalization. In contrast, the iPhone maker is 19th in the RAFI 1000, ranking below Wal-Mart (WMT - Get Report) and companies with large sales and other fundamental indicators.

Proponents of fundamental benchmarks say that their system is superior because it avoids giving great weight to the hottest stocks. Lately the fundamental approach has been outperforming. That has helped PIMCO Fundamental IndexPLUS to top the S&P 500. The RAFI approach has also excelled overseas. During the past three years, PIMCO Emerging Markets Fundamental IndexPLUS (PEFIX) has returned 12.4% annually, outperforming 94% of emerging markets funds.

At the time of publication the author had no position in any of the stocks mentioned.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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