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PIMCO’s Bond ETF Woes Widespread in Industry: Morningstar Expert

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The SEC is looking into how PIMCO values bond holdings in its $3.6-billion Total Return ETF (BOND) to find out whether it used discrepancies between the assets it bought at a discount and later re-calculated at higher values caused the company to overstate performance returns, according to reports published late Tuesday.

Regulators’ investigation of PIMCO has been underway for at least several months but appears to be gaining steam. An investment expert, though, says this is an issue that affects other fixed-income fund families, not just PIMCO.

“This is not a one-off event when it comes to price discrepancies in fixed-income funds,” said Michael Herbst, director of manager research for active strategies at Morningstar, in a interview with ThinkAdvisor.

“It may seem like it’s a one off, but it is not,” Herbst explained. “This kind of price discrepancies and potential discrepancies is great for the smaller, most nimble fund and is more common than some expect.”

The incidents of price discrepancy “will probably be greatest in funds that are most active in less-liquid holdings,” he adds. This includes non-agency residential mortgage-backed securities or other securitized products like collateralized loan obligations.

But even funds with high-yield bonds or other bonds with limited trading are likely to encounter the pricing issues, Herbst shares.

Which fund families are active in the space? BlackRock, DoubleLine, Loomis Sayles, TCW and Western Asset, he notes.

“I am not saying these firms” are likely to be investigated or to necessarily have pricing discrepancies in their holdings, Herbst explained, “but they do a lot of work in the less-liquid parts of the fixed-income marketplace”.

“The notion is more common than most [investors] realize, but it does not mean PIMCO has done anything wrong,” he added.

(See Ben Warwick’s blog for ThinkAdvisor on the liquidity issue, How Liquid Are Liquid Alts?)

Implications for Investors  

Given the complexities of pricing in the fixed-income market and the currect SEC investigation of PIMCO, what should investors be keeping in mind? 

The lesson, Herbst says, is to “keep an eye on actively managed ETFs that say they are using the same strategy as another fund in the space, particularly in the fixed-income space.”

“Many ETFs try to mimic an index as best they can,” Herbst explained. “ETFs that try to do this would not probably run into this issue as often.”

The research firm expects differences between PIMCO’s Total Return Fund and ETF – in terms of their holdings and performance – “to narrow over time as the ETF continues to gain assets” as the funds buy the same securities at the same time, Herbst adds.

If differences persist, though, the fund strategy “is not being applied uniformly,” he explains. “Nothing, in our opinion is wrong with the ETF structure that might be causing this. But discrepancies can come up with funds active in less-liquid parts of the fixed-income market.”

These challenges should remain, he says, “until bonds are as broadly traded as exchange traded stocks.” 

Fixed-Income Issues

BOND, which debuted in February 2012, is described on PIMCO’s website as “a diversified portfolio of high quality bonds that is actively managed in an effort to maximize return in a risk-controlled framework.”

The focus of the SEC’s investigation is on PIMCO’s valuation methods for small increments of mortgage securities or “odd-lots”, according to The Wall Street Journal. Pooling these mortgage securities into large quantities and assigning a higher value rather than pricing them as the odd-lots they are, could have given BOND an unfair performance boost.  

PIMCO like other firms that invest in hard-to-value assets is not alone in its scrutiny by the SEC for potential deficiencies. A lack of trading liquidity in both the bond market itself and with certain kinds of debt securities often forces investment firms like PIMCO to make certain assumptions about the value of those assets. When the assigned value of those assets doesn’t align with their true worth, problems can arise.

Although BOND is considered the ETF clone of the much larger $221 billion PIMCO Total Return Fund (PTTRX), the composition of both portfolios is not the same.

At the end of August, PTTRX held 41% in U.S. government debt, 20% in mortgage securities, and 13% in non-U.S. developed market debt whereas BOND held 36% in U.S. credit (a mix of investment grade and high yield debt), 27% in mortgage securities, 23% in non-U.S. developed market debt, and just 17% in U.S. treasuries.

PTTRX changes a lower annual expense ratio of just 0.46% compared to 0.55% for BOND, but requires a minimum $1 million investment.

In 2012, PTTRX, the company’s largest mutual fund, gained 10.36% but fell 1.92% in 2013. By comparison, BOND declined just 1.26% in 2013 and in 2012 didn’t have a full year of performance history. Through the Sept. 23 market close, BOND gained 5.03% vs. a 3.58% increase for PTTRX.  

While BOND gets most of the attention, the $4.04 billion-PIMCO 0-5 Year High Yield Corporate Bond ETF (HYS) and the $3.7-billion PIMCO Enhanced Short Duration ETF (MINT) are the company’s largest ETFs by assets, according to Morningstar.

“PIMCO has been cooperating with the SEC in this non-public matter, and we take our regulatory obligations and responsibilities to our clients very seriously,” according to a statement shared with the media. “We believe our pricing procedures are entirely appropriate and in keeping with industry best-practices.”

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