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How Gross beats the average bond fund?

PIMCO Total Return outperformed its benchmark over the decade through July 2012 with an average annual pre-tax return of 6.6% from inception through July. That beat both the Barclays Capital US Aggregate Bond Index (Agg) of pre-tax 5.7% gain and the pre-tax 5.3% average of the funds in fund-tracker Lipper Inc.’s intermediate-term investment grade category, according to PIMCO.

The Agg has reflected the market since Lehman Brothers launched it 1986. Acquired by Barclays in 2008, the index now includes more than 7,900 issues, worth almost $17 trillion.

How has Gross did it?  Through the use of strategies to maximize total return by emphasizing potential capital appreciation from declining interest rates, currency appreciation, and improving credit fundamentals of companies and governments that issue debt securities.

Here are examples:

  1. Optimizing Sector Allocation - Instead of matching changes in public and private sectors’ shares of the total taxable U.S. investment grade bond market — of which Treasurys, government agency mortgage-backed securities (MBS), and corporates constituted 87% on July 31 — Total Return may overweight sectors with improving prospects. (For example, agency MBS accounted for 46% vs. 29% in the index.)
  2. Managing interest rate risk measure - Gross manages the portfolio’s average duration — a key measure of a bond’s or bond-fund’s sensitivity to increases or decreases in interest rates — so that it “normally varies within two years (plus or minus)” of the Agg’s, depending on whether he expects higher or lower rates.  “If a manager extends duration relative to the benchmark just as rates decline, that’s probably a home run hit,” said Jeff Tjornehoj, Lipper Americas senior research analyst. (A 1% decrease in interest rates would result in a 5% increase in price for an intermediate-term portfolio with an average duration of five years, for example.)  While the Agg’s intermediate-term duration ran between 3.7 and 5.2 years at the ends of the last 40 calendar quarters, Total Return’s duration has fluctuated more widely. At the end of 2011’s third and fourth quarters, respectively, its duration topped seven years, exceeding the index’s by slightly more than two years.
  3. MP900424384Investing beyond the benchmark - Total Return may invest beyond the taxable U.S. investment grade bond market: up to 10% of assets in junk bonds with prospects for upgrades, and up to 30% in securities denominated in foreign currencies, for example.
  4. Leveraging - The fund uses leveraging, including borrowing, in various transactions, including those involving derivatives and when-issued, delayed delivery, or forward commitments. Leveraging “may cause a Fund to be more volatile,” Pimco’s prospectus explains, “because (it) tends to exaggerate the effect of any increase or decrease in the value of a…portfolio.”
  5. Frequent Trading - “The Fund may engage in frequent and active trading of portfolio securities to achieve its investment objective,” an annual report footnote says, alerting investors to high portfolio turnover (584% in the last fiscal year) and the taxable short- and long-term capital gains distributions it engenders.

Reference:  MarketWatch, Werner Renberg, 2012-09-04, “How PIMCO’s Gross Beats the Average Bond Fund”