Bill Gross: the once and future bond king? (Photo: Jim Tweedie)

Can a bond king once deposed regain his crown?

It’s happened before.

Just as Napoleon was forced into exile on the island of Elba, escaped and returned to power, so too may Bill Gross find that portfolio management free from the constraints imposed by the PIMCO Total Return Fund’s (PTTRX) massive size could pave the way to his return to reign.

Ensconced as he is in the new and nimble Janus Unconstrained Fund (JUCIX), Gross may now, ironically, be better positioned to snatch back contested bond king status from the interloper Jeffrey Gundlach whose DoubleLine Total Return Bond Fund (DBLTX) has outperformed PTTRX in recent years.

Those are among the implications of a study out this week by Claude Erb, a former money manager at TCW Group, who argues that bond king fund alpha declines as assets under management rise.

Erb’s study looks at the historical performance of the fixed-income market’s two bond kings, Gross and Gundlach, and finds that a doubling of assets under management led to a 10%-20% reduction in alpha, the unique skill a manager brings to beat the market.

The reason he adduces is that there is only a fixed amount of mispriced securities to which these managers can apply their skill, such that an increased asset base dilutes the effect of that skill over their portfolios, or as Erb puts it, “too much capital [is] chasing too few opportunities.”

A chart displaying the historical relationship between fund size and alpha vividly shows Gundlach’s market-beating, and PTTRX-beating, performance over the past four years to be sure.

But it also shows a distinct downward performance slope for both funds as they increased in asset size, suggesting that what is good for the Gross is good for the Gundlach — in other words, that Gundlach’s outperformance is due to peter out.

That notion is based on what Erb calls “naïve extrapolation,” which merely looks at historical performance without investigating the possibility of other potential causal factors at play.

But in a regression analysis using this assets-under-management-based approach, Erb forecasts that Gross’ new fund could achieve alpha of about 10% compared with Gundlach’s fund alpha of 3% and Gross’ old fund alpha at less than 1%.

That extrapolation is based on the relative performance of PTTRX and DBLTX over the past four years. The former $200 billion-plus fund has only slightly outperformed the broader bond market, some of whose investors have migrated to the nimbler $35 billion fund run by Gundlach.

But DBLTX’s very success, like that of PTTRX before it, has swollen assets and suggests a lower-performing future.

Erb acknowledges that the trend he observes may merely be a “historical curiosity” rather than a stable relationship observable in the future. “But there is only one history and one historical relationship,” he writes.

This relationship suggests, ironically, that the continuing redemptions at PTTRX could end up improving the fund’s alpha potential as its asset base diminishes.

And while bond investors tend to set before them a bond king, which simplifies investing for them, Erb mentions the possibility that non-monarchical investors might prefer to repose their trust in an investment committee, such as the managers who run the Angel Oak Multi-Strategy Income Fund (ANGIX) as a team.

That fund’s small size may confer the advantage Erb has observed — he titles his paper “Small is Beautiful” — in funds whose managers are skilled enough to exploit the finite number of mispriced securities within a manageble asset base.

But for the majority of investors who believe in bond kings, Erb concludes that history suggests they would do well to flee the big tyrant and rather commit their loyalty to the smaller bond king.

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