Wisdom of the Market

PIMCO: Just How Consistent is Consistent?

Wisdom of the Market

In Bill Gross’s December 2013 Investment Outlook letter, he joined the ranks of Warren Buffett and Peter Lynch in giving a solid endorsement to indexing while reminiscing about his younger days when Jack Bogle introduced the first index fund available to retail investors:

“His [Bogle’s] early business model at Vanguard promoting index funds was a mystery to me for at least a few of my beginning years at PIMCO. Why would most investors be content with just average performance, I wondered? The answer is certainly now obvious; an investor should want the highest performance for the least amount of risk, and for almost all measurable asset classes, index funds and many ETFs have done a better job than almost all active managers primarily because of lower fees.”

Of course, the catch is “almost all”, and Gross clarifies his meaning when he says, “PIMCO is a $2 trillion active manager with lots of long-term consistent alpha.” Gross cites a recent Morningstar interview in which Jack Bogle alluded to the “PIMCO effect” as a reason why some investors gravitate towards active rather than passive. The essential idea is that the existence of one or a few managers with “consistent positive alpha” justifies investors choosing to go active. However, as we have stated in many past articles, alpha is no more prevalent than what we would expect purely from chance, and there is no proven reliable way to identify alpha in advance of its occurrence.

Both PIMCO and Bill Gross have become synonymous with the PIMCO Total Return Fund (PTTRX), which at $244 billion is the second largest mutual fund in existence, second only to the Vanguard Total Stock Market Index Fund. If Gross had left his alpha claim at that, we would let it ride. Since Gross’s claim of consistent alpha was for all of PIMCO, we decided to compare all the PIMCO funds to their Morningstar analyst-assigned benchmark. We limited ourselves to the 47 funds that have at least five calendar years of data. While 34 of the 47 (72%) had positive alpha, only 4 (or 9%) had alpha that was reliable to the degree that we would rule out luck as the explanation with a 95% level of confidence. PTTRX was one of those funds, but as Mr. Gross implied in one of his prior letters, luck played a substantial role in that leverage was used during a time period when it yielded a handsome payoff. As Gross so eloquently put it:

“All of us, even the old guys like Buffett, Soros, Fuss, yeah—me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, than an investor could experience…An investor that took marginal risk, levered it wisely and was conveniently sheltered from periodic bouts of deleveraging or asset withdrawals could, and in some cases, was rewarded with the crown of ‘greatness.’ Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.”

The other threee funds that had significant alpha also employ leverage, and as we discussed in this article, leverage is a double-edged sword. It is important to note that in this analysis, we are only looking at surviving funds. Based on Morningstar data, we counted 9 PIMCO funds that have been liquidated, which means that an investor choosing a PIMCO fund prior to 2008 had only a 7% chance of selecting a fund that ended the Dec., 2012 period with a statistically significant alpha, meaning that there was a 95% chance that the past excess returns over the benchmark were considered the result of skill rather than luck, according to this test). Please review the formula and input form at this link to better understand this type of analysis. This article titled What's the Significance?, is for the advanced students of financial analysis. Finally, this article titled The Paradox of Skill provides further background information on the question of stock picking skill.

IFA will always counsel investors to rely on the collective wisdom of the market for their long-term returns. Reliance on the opinions of one or a few people, no matter how intelligent and knowledgeable, is simply taking on an unnecessary risk that actually has a negative expected return relative to the benchmark. Even if an investor is so fortunate as to find the manager that beats a risk-appropriate benchmark over the long-term, it is virtually guaranteed that the investor will have to endure time periods when the manager underperforms the benchmark, according to a recent Vanguard1 study. Furthermore, this underperformance often occurs when another manager is showing outperformance, leading investors to second-guess their initial decision to go with their current manager. If you are on such a treadmill, IFA’s best advice is to step off it immediately.

1Wimmer, Brian R., Sandeep S. Chhabra, and Daniel W. Wallick, 2013. The Bumpy Road to Outperformance. Valley Forge, PA: The Vanguard Group.