2014 has been the year in which the derivatives strategy of the cat loving, sun-glass touting Bill Gross has been revealed to new degrees. And the hits just keep on coming as the PIMCO’s total return fund’s exposure to Chinese SWAP derivatives, cousins of the derivatives that imploded in 2008, is revealed.

Pimco Bill Gross
Bill Gross at the Morningstar conference in Chicago – June 19th 2014

At the end of the first quarter, PIMCO’s flagship Total Return Fund, assumed as a relatively “conservative” bond fund in search of yield, has nearly $3 billion in insurance derivatives it sold on China’s sovereign debt, a new Reuters report revealed.

PIMCO’s “short volatility” play

The Chinese real estate and associated markets have been referred to as a potential bubble. If interest rates were to suddenly rise in the Asian nation, PIMCO’s “short volatility” play could cause PIMCO to be liable for large insurance payments.  Short volatility strategies are known to generate consistent month over month returns but are vulnerable to significant market crashes.  PIMCO, like much of the big bank derivatives $600 trillion on derivatives exposure, is significantly exposed if interest rates were to rise rapidly in a short period of time.

“There is nothing wrong with selling insurance,” Bill Gross said at the recent Morningstar conference in Chicago.

While hedging against the Chinese SWAPs derivatives exposure is possible, generally speaking hedging SWAPs exposure becomes more difficult in developing markets in which highly liquidity lacks and the ability to cross margin with other products due to the lack of correlating derivatives products.

Hedge fund insiders have noted the rise of PIMCO and its industry leading bond fund has come during a historic move lower in interest rates has occurred.  When interest rates drop the value of bonds that Gross purchased rise in value. With some yield curve observers noting that bond yields, sitting on all time lows, could move higher, particularly as the US Federal Reserve loosens its historic iron-clad grip on interest rate markets.

PIMCO having difficulties with new market environment

Gross is not only faced with having difficulty finding appropriate bond yield, but potentially is faced with a new market environment where US interest rates trend higher.  Bonds that PIMCO purchases, particularly those of longer durations, will fall in value in a rising rate environment.  How PIMCO manages this rising rate environment could be the most significant challenge to the company in its history.

To manage this process, PIMCO appears to be increasingly turning to derivatives. Gross developed a highly successful formula using derivatives to manage the bond market as rates were falling. While the formula might need adjusting to various degrees as US bond rates rise, if PIMCO’s managers can pull this trick out of their hat it will be one for the history books indeed.

PIMCO’s core under performance question

That said, the firm struggles amid investors exiting the fund. The core of PIMCO has come under question recently.  Just today, Pensions and Investments magazine questioned Gross’ claim that his fund has been outperforming the market. The magazine said the world’s largest bond fund, which is trying to recover from more than a year of underperforming most of its competitors, is pointing to returns in the second quarter (up 2.37%) and June (0.37%) that ranked in the top 23rd and 13th percentiles, respectively, for the institutional share class. 

But performance metrics that take risk into account point to no such rebound — and might, in fact, point to increased risk,” the article said. “The fund has underperformed its competitors, and a benchmark index, on the Sharpe ratio, a key risk-adjusted performance metric, every month since October 2011.”

The enhanced risk and volatility may be due to derivatives as well as the Sharpe Ratio used to measure risk / reward ratios. Sharp’s Nobel Prize winning formula assigns equal risk weighting to upside (positive) volatility as it does downside (negative) volatility. Many derivatives-based investment strategies tend to be penalized due to the weighting of upside deviation.

Regardless, PIMCO, predictably, disagrees that his fund has underperformed while often ignoring traditional risk and reward metrics in public comments.

“The Total Return Fund, long lambasted as underperforming, is outperforming its index by a decent margin, before fees,” Gross said at the Morningstar Investment Conference last month. “It does what a customer wants it to do and that’s to outperform with less risk on a consistent basis.”