Pimco Looks to Clone ETF Success

How do you follow up one of the most successful exchange-traded fund launches in history? You start three more, of course. Ba-dum-bum-CHING

Last year, Pimco, the Newport Beach, Cal., bond giant, launched Pimco Total Return Exchange-Traded Fund (symbol BOND). It now has $5.3 billion in assets. The draw: BOND is actively managed, unlike most ETFs, which are tied to an index. Also, it's run by Bill Gross, who uses the same strategy he's become famous for at Pimco Total Return (PTTDX), which, with $293 billion in assets, is the world's biggest mutual fund. And then there's the ETF's outsize return: From its February 2012 inception through May 8, BOND returned a cumulative 14.2%. The mutual fund, by contrast, gained just 8.5% – more on that later.

In the wake of BOND's success, Pimco is getting ready to bring out three more actively managed ETFs: Pimco Diversified Income Exchange-Traded Fund (DI), Pimco Real Return Exchange-Traded Fund (symbol not available yet) and Pimco Low Duration Exchange-Traded Fund (LDUR). Like BOND, each new ETF mirrors the strategy of an existing Pimco mutual fund that bears a similar name. Bill Gross will co-manage all of the funds, with Curtis Mewbourne on Diversified Income, Marc Seidner on Low Duration and Mihir Worah on Real Return. "These three ETFs are designed to provide income and preserve purchasing power," says Don Suskind, head of ETF product management at Pimco. "They line up with what we think investors need."

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Official launch dates haven't been released. But the ETFs will copy the strategy of their traditional fund counterparts, so we took a closer look at the originals, all of which have long track records. At first glance, it seems that Pimco chose wisely. Each fund is a standout in its category, ranking in the top 25% over long stretches of time. They also are timely choices – all three are well-positioned for an eventual rise in interest rates, as well as impending inflation. We scrutinized the no-load Class D shares of the funds. Returns are through May 8.

Pimco Diversified Income (PDVDX).Curtis Mewbourne leads this multisector bond fund, which invests worldwide in three main buckets: investment-grade corporate IOUs, high-yield corporate bonds and emerging-markets debt. As other Pimco managers do, Mewbourne first takes into account the big-picture view of the firm's investment committee before deciding which of the three major sectors offers the best value. These days, it looks to be emerging-markets debt. At last report, the fund held 55% of its assets in such bonds. Mewbourne is leaning toward high-quality issues in countries with low amounts of outstanding debt (relative to the size of their economies) and a central bank that operates independently from a country's executive and legislative branches, such as Mexico and Brazil. Since Mewbourne took over the fund in October 2005, it has returned 8.1% annualized, beating the typical multisector bond fund by an average of 1.8 percentage points per year. The fund currently yields 2.6%.

Pimco Real Return (PRRDX)."Real return" is not just a catchy turn of phrase. It refers to the rate of return after adjusting for inflation. In this fund's case, the term reflects its objective: It seeks to offer shareholders a meaningful return above the rate of inflation, as measured by the consumer price index, by investing in inflation-indexed bonds, such as Treasury Inflation-Protected Securities (TIPS). Mihir Worah, Pimco's inflation guru (in addition to Real Return, he runs other funds with strategies that are tied to inflation-index bonds), can also invest in inflation-indexed bonds issued by other countries. But lately he's been staying close to home. At last report, the $24.4 billion fund had 92% of its assets in TIPS. Over the past five years, the fund earned 6.5% annualized, which beats 94% of its peers in the inflation-protected bond category. Its current 30-day yield is 1.9%.

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Pimco Low Duration (PLDDX). Investors worried about a rise in interest rates will probably gravitate toward Low Duration, which is managed by Gross. That's because the fund maintains an average duration (a measure of interest-rate sensitivity) of between one and three years, which means it is relatively insensitive to interest rate moves. (For example, a fund with an average duration of two years would likely experience a 2% decline in value if interest rates rose one percentage point.) At last report, Low Duration had an average duration of 2.7 years. The $25 billion fund recently held a large slug in mortgage bonds (39% of assets), U.S. Treasuries (8%), investment-grade corporate debt (7%) and emerging-markets debt (5%). Its current 30-day yield is 1.0%.

As expected, the ETFs will charge lower expenses than the D-share class of their fund counterparts: Low Duration ETF and Real Return ETF will charge 0.55% per year each, versus 0.75% and 0.85%, respectively, for their corresponding funds. Diversified Income ETF comes in higher at 0.85% a year, compared with 1.15% for the mutual fund.

But these ETFs aren't cheap. In fact, the expense ratios of the mutual funds' institutional share classes are even cheaper. Real Return's institutional shares cost 0.45%, and Low Duration's cost 0.46%. Diversified Income's institutional class shares come in at 0.75%. And the ETFs are more expensive than the typical taxable bond ETF, which charges just 0.32%, on average, in annual fees.

Finally, you can't assume the ETFs will mirror the returns of their fund counterparts. If they're anything like BOND, they may deliver a higher return than their respective fund twins right out of the gate. Part of the reason BOND did so well in its first year was its fresh start. It benefited from being more nimble and new. Its billion-dollar-plus portfolio, albeit large for a new ETF, was nothing compared with its enormous mutual-fund sibling. And it wasn't weighed down by existing holdings; the firm was able to fill the ETF with its best ideas.

Many factors, says Suskind, can contribute to a variation in performance: "We have many accounts that follow similar strategies, but the size of the portfolio, the timing of cash moving in or out of the portfolio, what they can invest in and how much they can invest in certain types of securities all contribute to the portfolio construction and can result in different returns."