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.

Will the ETF continue outperforming by a wide margin? Probably not, says Timothy Strauts, an ETF analyst for Morningstar. As the ETF grows larger, the gap between the two Pimco funds will close. Still, he figures that the ETF could outperform the mutual fund over the next several years.

"I would doubt that the ETF can continue outperforming by 4%," he says. "But it could be half a percent or one percent better," he says.

Besides delivering higher returns, the ETF is cheaper for many retail investors. The ETF has an expense ratio of 0.55%, compared to 0.85% for the Class A retail shares. Institutional shares of the mutual fund cost 0.46%. Strauts recommends the ETF for new investors. But longtime shareholders of the mutual fund may not want to switch. Selling fund shares can generate capital gains tax bills.

Pimco has taken pains to say the ETF and mutual fund are not identical. While the mutual fund trades options and credit default swaps, the ETF is not permitted to use derivatives. So far many of the derivatives have been a burden on the mutual fund, says Strauts of Morningstar. Credit default swaps act like insurance policies against bond defaults. An investor pays for the swaps and receives compensation if trouble strikes.

Because the bond market has been calm lately, Pimco has paid for the swaps and received little benefit. But if the market turns volatile, the swaps could produce dividends, says Strauts. "If another panic appears, the credit default swaps would start paying out, and the mutual fund would have an advantage over the ETF," he says.

Despite their differences, the two funds resemble each other in key respects. Both funds are run by Gross and have the same broad asset allocations. While the mutual fund has 8% of its assets in emerging markets, the ETF has 9%. Odds are good that over the long term the funds will deliver similar returns.

Last year, Gross stayed away from Treasuries, a move that caused the mutual fund to trail the benchmark. After making a much-publicized apology, Gross switched course. This year he has big stakes in government and high-quality mortgage-backed securities. That has proved to be a winning move. In recent months, both the ETF and the mutual fund have outpaced their benchmark.

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

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

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