When PIMCO talks, the market listens. Bill Gross, Mohammed El-Erian, and Paul McCulley provide consistently insightful, thought-provoking and entertaining market commentaries. As evidence of the power of their words, PIMCO’s forecast of a New Normal has become a paradigm for market analysis.
But we mustn’t forget that the bulk of PIMCO’s revenue comes from actively managing bond portfolios. So when PIMCO claims (as they did in a recently published paper, Approaching TIPS Allocations in the World of the “New Normal”)that alpha can be earned by actively managing Treasury Inflation Protected Securities (TIPS), a healthy dose of scrutiny is warranted.
That scrutiny should cause investors to avoid such a product, if it is ever offered.
PIMCO’s paper, written by John Cavalieri, Gang Hu, and Mihir Worah, points to four areas of inefficiency in the TIPS market.
Due to the TIPS market’s small size (approximately 8% of the nominal Treasury bond market), the authors argue passive investors incur larger transaction fees than active investors, like hedge funds. Passive investors, such as the ETFs (e.g., the iShare TIP fund), typically transact at the end of the day, and the authors contend that active investors can time their transactions during the day to take advantage of market imbalances that might occur at the end of the day.
Second, indices that track the TIPS market (such as the index used by the TIP ETF) are rebalanced periodically. By anticipating which securities will be bought and sold when passive investors rebalance, or by purchasing securities at what might be artificially depressed prices after rebalancing, active investors can capture alpha.
The authors also cite evidence that TIPS auctions create market inefficiencies. Historically, TIPS prices have cheapened before those auctions, which the Treasury conducts eight times per year, and richened post-auction, offering another source of potential alpha.
Lastly, the authors point to seasonal patterns in TIPS pricing. They contend that prices richen and cheapen corresponding to seasonal patterns in the underlying inflation (CPI-U) index issued by the government.
In addition to these four “structural inefficiencies,” the authors claim they can gain a performance advantage by positioning their portfolio on specific durations or by taking advantage of changes in the shape in the yield curve.
I am not persuaded. I doubt that active managers can outperform a passive fund, such as TIP, net of fees.
Fees generally dictate the ultimate fate of bond investors. TIP’s fees are a modest 20 basis points, but PIMCO’s fees for active management are generally between 75 and 100 basis points, setting a high hurdle for successful active management – and giving portfolio managers an incentive to take excessive risks.
Don’t forget that 10-year TIPS currently yield just under 2%. Passive investors already sacrifice 10% of their returns in management fees; fees for active management could consume nearly half of that yield.
