By Daryl Jones, Hedgeye
FORTUNE -- For those of you who missed it in high-school history class, Sir Ernest Shackleton is the best-known figure in the "Heroic Age of Antarctic Exploration," which began in 1911 after Roald Amundsen successfully reached the South Pole. Shackleton was a maverick. He wanted to one-up Amundsen. So he set forth raising funds for his journey and eventually launched the ill-fated "Imperial Trans-Antarctic Expedition" to cross the frozen continent's tundra. Mother Nature of course had other plans. Misfortune beset Shackleton and his crew early on when an ice flow froze his ship, The Endurance. The ship was abandoned.
For the next 500 days, Shackleton and his men were stranded. They had no contact with the outside world and routinely faced temperatures below -50 degrees Celsius. Fortunately, after an almost impossible trip to a nearby whaling station, the entire crew was rescued. Even though the expedition fell short of its goal, Shackleton and his crew walked away with their lives and some harsh polar perspective.
While obviously nowhere near the difficultly endured by Shackleton, for many hedge fund managers, this has been a year to gain perspective (if not outperformance). Take a look at the Hennessee Hedge Fund Index which was up 9.9%, as of the end of October 2013 -- a return that paled in comparison to the S&P 500's (SPX) return north of 23%. While returning close to 10% on "2 and 20" hedge fund fees isn't the worst thing in the world, for most hedge fund managers, underperforming a passive strategy by over 1,000 basis points can lead to investor ire and redemptions.
One key reason for the underperformance of hedge funds is the outperformance of heavily shorted stocks. Heavily shorted stocks are outperforming the S&P 500 by a staggering 570 basis points this year. That said, long and short equity managers aren't the only investment managers playing catch-up with the market this year. PIMCO's Total Return Fund (BOND) has returned a capital eroding -0.87% in the year-to-date. Clearly, PIMCO's Bill Gross and the big bond boys are experiencing some performance issues.
The broader issue with bond managers like PIMCO is how far afield they have journeyed in search of yield. And therein lies the key question: At what cost does this hunt for yield come?
As it relates to the PIMCO Total Return Fund, prospective underperformance may even be more concerning given the fund's holdings and where the managers have gone to find yield. According to analysis by our Financials Team here at Hedgeye, almost 34% of PIMCO Total Returns holdings are in agency Mortgage Backed Securities (MBS). Check out the chart below highlighting the spread of agency MBS to the 10-year Treasury Yield.
Prior to the financial crisis, this spread was around 126 basis points. It has now narrowed to approximately 68 basis points. In other words, the almighty chase for yield has effectively priced mortgage backed securities to one of the lowest levels of risk that we've seen in the asset class. Even if the spread for Agency MBS normalized by just 50 basis points, to pre-crisis levels, it would have a meaningful impact on the market. By our estimation, allowing for modified duration, a 50 basis increase (reversal of tapering for instance) in yield would lead to 5% downside in the Agency MBS market.
The issue for firms like PIMCO is that a 5% correction in one of its more significant asset class exposures is likely to lead to continued underperformance and accelerated outflows. Outflows and decreased liquidity, of course, are only likely to exacerbate any move in price in the MBS market.
The Financial Times emphasized this point further in a recent article looking at managers of collateralized loan obligations (CLOs). According to the FT, managers of CLOs have increased the proportion of risky loans that their investment vehicles are allowed to buy to the highest level on record. Currently, 55% of new leveraged loans come in the covenant-lite form, which eclipses the 29% reached shortly before the financial crisis.
In theory, when the economy is stable, covenant-lite loans are fine. But, if there is volatility in economic activity, these loans get much more difficult to repay for many corporates. A good analogy is probably Shackleton and his crew in -50 degrees Celsius weather in Antarctica. You know weather that cold is dangerous but it is survivable, until the wind starts to blow and wind chill sets in.
Given the challenges faced by large asset allocation funds that rely heavily on yield for performance, going forward it might be prudent that managers of these funds search for analysts for their investment teams with a similar advertisement to what Shackleton used to find his crew:
"Men wanted for hazardous journey. Small wages. Bitter cold. Long months of complete darkness. Constant danger. Safe return doubtful. Honour and recognition in case of success."
Daryl Jones is the Director of Research at Hedgeye Risk Management.
Vanguard is challenging BlackRock and State Street for dominance. It's a battle of titans - and investors are the winners.
By Erika Fry, reporter
FORTUNE -- Vanguard rose to the pinnacle of the mutual fund world with a simple but potent formula: an emphasis on low fees and index funds. These days Vanguard is applying that same philosophy to a fast-growing sector of the investing universe already built around low-cost indexing: MOREJan 29, 2013 5:00 AM ET
Bond fund chief says if Washington doesn't do something, our kids will be worse off.
FORTUNE -- PIMCO, the huge asset manager, has mapped out a contingency plan for what to do with its clients money should the U.S. go over the so-called Fiscal Cliff.
Speaking at FORTUNE's Most Powerful Women Summit on Wednesday, PIMCO's CEO Mohamed El-Erian said the U.S. economy will certainly collapse into a recession if Congress does nothing MOREStephen Gandel, senior editor - Oct 3, 2012 6:32 PM ET
His strategies are used to manage $100 billion - and he's seeing hopeful signs in emerging markets.
FORTUNE – Rob Arnott is one of the few major investors who buys and sells almost any asset anywhere in the world. Not only does he manage Pimco's $27 billion All Asset Fund (PASAX), but as chairman of Research Affiliates he has also devised strategies used to manage $100 billion. Arnott is the father MOREShawn Tully, senior editor-at-large - Jun 4, 2012 5:00 AM ET
Bond king Bill Gross says it's time to get your portfolio ready for a long-period of lower market returns.
FORTUNE -- Apparently, Bill Gross picks movies as well as investments.
Bond investor Gross, who runs the world's largest mutual fund Pimco Total Return (PTTRX), is known for his quirky letters to investors. In the past he has dispensed love advice (specifically for Europe) and written about why he hates automatic flush toilets. MOREStephen Gandel, senior editor - Mar 28, 2012 5:00 AM ET
Pimco is launching an ETF to track the biggest mutual fund, its Total Return Fund. Will this portend the end for mutual funds? We looked into the future to find out, and this 2022 story tells it all.
By Joshua Morgan Brown, contributor
March 1, 2022
FORTUNE -- Ten years ago, in March of 2012, the world's largest mutual fund cloned itself as an ETF. It occasioned a small amount of business media MOREJan 24, 2012 11:13 AM ET
The guys at Pimco are letting their imaginations run a little wild.
First Bill Gross called for a bond market turkey shoot and bet against U.S. government bonds just before they staged a big rally. Now one of his functionaries, portfolio manager Scott Mather, is warning about "financial repression."
That sounds vaguely Freudian, though it actually refers to the process of holding down interest rates to help pay down ridiculous government debt loads. MOREColin Barr - Jun 20, 2011 4:28 PM ET
A little Treasury rally doesn't faze the loquacious bond bear Bill Gross.
Gross, the manager of the world's biggest bond fund, increased his bet against U.S. government debt last month while adding to his record cash position – even as bond prices rallied.
Gross' Pimco Total Return fund held 43 cents of cash for every dollar it had in assets, according to data from the end of April (see chart, right). That's MOREColin Barr - May 10, 2011 10:31 AM ET
The coming bond market bloodbath won't necessarily look all that bloody.
So says the shy and reclusive Bill Gross, who is out Tuesday with his latest monthly investment outlook. Gross, who runs the world's biggest bond fund at Pimco, has been screaming for months that the sky is falling in the government bond market, thanks to an untenable U.S. fiscal position and all the problems that come with it.
But in the MOREColin Barr - May 3, 2011 1:32 PM ET
Buyout firms looking to cash in on their brand equity have either gone public or sold shares to a sovereign wealth fund. Now, there's an alternative.
PIMCO boss Mohamed El-Erian last week confirmed reports that firm employees were buying and selling equity via SecondMarket, the private online marketplace for alternative assets. Now it seems that PIMCO is just the tip of a much larger iceberg.
Jeremy Smith, chief strategy officer for SecondMarket, tells MOREDan Primack - Apr 4, 2011 12:34 PM ET
|Don't fight it. Bitcoin has a bright future|
|Teen millionaire helping Yahoo become cool again|
|"The Hobbit" dispute sparks lawsuit|
|Five things you didn't know about Bernie Madoff's epic scam|
|Stocks falter as budget deal raises taper risk|