Bill Gross says the exchange-traded version of his $250 billion Pimco Total Return Fund has the potential to become the first hot seller among actively managed ETFs. Investment advisers are giving the fund a cool reception.
“We would just stick with the Total Return Fund rather than going to the ETF,” because the ETF won’t have the same use of derivatives to increase returns as the traditional fund, said Brian Pollak, fixed income portfolio manager for New York-based Evercore Wealth Management LLC, which oversees about $3.2 billion.
Gross, co-chief investment officer of Pacific Investment Management Co., the Newport Beach, California-based unit of insurer Allianz SE, is the most prominent professional to start an actively managed ETF. The flagship Total Return Fund he runs has generated 8.4 percent average annual returns over the past five years, and Morningstar Inc. named Gross a fund manager of the decade in 2010.
Assets in ETFs, which generally are baskets of securities that trade on exchanges like stocks, rose to about $1.1 trillion in January from about $66 billion in 2000, according to the Investment Company Institute, a Washington-based trade group for the mutual-fund industry.
Yet actively managed ETFs, which seek to benefit from the skill of a manager selecting investments rather than tracking indexes, haven’t gained significant traction among investors as assets are less than 0.5 percent of the total invested in ETFs, according to ICI data.
Registered investment advisers are a “growth driver” for the ETF industry, said Tyler Cloherty, senior analyst for Cerulli Associates. RIAs are firms that manage or provide advice on investments and generally charge fees for services, compared with broker-dealers that more commonly charge commissions.
About 15 percent of assets under management by advisers were invested in ETFs in 2011, up from about 8 percent in 2009, according to the Boston-based market research firm. Advisers account for about 10 percent of total assets invested in ETFs.
Pimco in April filed to start an ETF that Gross will manage and may invest in a similar strategy as his Total Return Fund. The ETF will invest primarily in a diversified portfolio of fixed-income assets, including government bonds and mortgage-backed securities.
Restrictions on Derivatives
Unlike the flagship mutual fund, the Total Return ETF can’t use certain derivatives, such as futures, options and swap agreements, according to documents on the Pimco website. Derivatives are financial instruments used for speculation or to hedge risks, and generally derive their values from an underlying asset.
“If you believe Bill Gross and Pimco are diligent and thoughtful about the use of derivatives, then why wouldn’t an investor employ Bill Gross with the ability to use derivatives?” said Alan Zafran, a partner with Los Angeles-based Luminous Capital, which manages about $4.7 billion.
The U.S. Securities and Exchange Commission in March 2010 stopped approving applications for ETFs that would make “significant investments” in derivatives, pending a review examining whether additional protections are necessary for funds that do so.
“There’s a tool in their toolkit that they don’t have access to,” without the full use of derivatives, Evercore’s Pollak said.
Advisers who prefer buy-and-hold investing may not find the ETF’s trading feature useful, said Mark Green, chief investment officer of Carmel, Indiana-based Oxford Financial Group Ltd., which manages about $10 billion.
“No one day trades bond funds,” said Jonathan Bergman, chief investment officer of Scarsdale, New York-based Palisades Hudson Asset Management LP, which oversees more than $1 billion on behalf of individuals and families. “The fact that it’s available intraday is inconsequential.”
The ETF will charge 55 basis points in annual expenses after accounting for a fee waiver, according to fund documents. That compares with 46 basis points for the traditional fund’s institutional shares, which generally are used by advisers. A basis point is 0.01 percentage point.
“If you already own the Total Return Fund with a lower fee, it’s hard to see why you’d want to go into the Total Return ETF with a higher fee other than for more liquidity,” Gross said in an interview on Feb. 29, referring to holdings of the institutional shares among advisers.
“We’d prefer the open-end fund,” meaning the traditional fund, for its greater flexibility with derivatives and lower expense ratio, Zafran said.
Actively managed ETFs received about $1.4 billion in deposits in the 12 months through January, compared with about $108 billion for ETFs that track an index, according to Morningstar. There are almost four times as many index ETFs as active ETFs.
“With just a few exceptions, overall asset flows into active ETFs have been not great,” said Robert Goldsborough, ETF analyst for Chicago-based Morningstar. “By the same token, not a lot of ETF providers have come up with actively managed ETFs.”
In June, Atlanta-based Invesco Ltd. said it would liquidate two actively managed ETFs -- PowerShares Active Alpha Multi-Cap Fund and PowerShares Active AlphaQ Fund. Columbia Management Investment Advisers LLC, a unit of Minneapolis-based Ameriprise Financial Inc., in April said it had agreed to acquire actively managed ETF firm Grail Advisors LLC. Columbia’s five actively managed ETFs have about $23 million in assets, according to data compiled by Bloomberg.
Largest Active ETF
The Pimco Total Return ETF may benefit, compared with offerings from smaller firms such as Grail, from Pimco’s existing brand, distribution and marketing, Goldsborough said.
“There’s a lot of inherent advantages to what Bill Gross has,” he said. “There’s an untested aspect to a smaller firm that isn’t there with a bigger firm like Pimco.”
The Pimco Enhanced Short Maturity Strategy Fund is the largest actively managed ETF. The fund invests primarily in short-duration investment-grade securities and is managed by Jerome Schneider, and has about $1.4 billion in assets. The fund returned about 1 percent for the year ended Feb. 29, Bloomberg data show.
Investors who currently hold higher-expense share classes of the traditional fund may consider switching to the ETF for the cost savings, said David Hallman, vice president of investment research and management for Newport Beach, California-based United Capital, which with its affiliates oversees about $16 billion.
‘Mom and Pop’
The ETF may appeal to “mom and pop” investors, Gross said. The fund’s annual expenses are lower than those of the A, C and D share classes of the flagship fund, where costs range from 0.75 percent to 1.6 percent.
“The challenge is obvious,” Gross said. “We could fall flat on our face or we could roar like a lion in a year or two or three and become the largest ETF.”
The Pimco Total Return ETF had about $103 million in assets and traded at a 4 basis point discount to its net asset value as of its first day of trading yesterday.
Bond ETFs may be more likely to trade at substantial premiums or discounts to their net asset values than stock ETFs, said Michelle Knight, chief economist and managing director of fixed income for Boston-based Silver Bridge Capital Management, which oversees about $3.2 billion for families and institutions.
In January, taxable bond ETFs traded with an average monthly premium of 23 basis points, compared with an average monthly discount of 4 basis points for U.S. stock ETFs, according to Morningstar. The average monthly premium for taxable bond ETFs during 2008 widened to as much as 1.87 percent.
“To me, that’s a bigger deal than anything else -- that disconnect,” Knight said.