Small Is Beautiful: ‘Bond King’ Expected Alpha and Assets Under Management

Claude B. Erb

TR

September 30, 2014

Abstract:

Many fixed income investors allocate assets to funds managed by “bond kings” with the expectation of achieving significant market beating “alpha”. The investment performance of “bond kings” reflects the intersection of 1) those perceived to be skilled at identifying and exploiting mispriced securities and 2) the availability of investment capital. Historically, the value-added, the alpha, of “bond kings” has declined as the availability of capital has increased. As an empirically observed historical rule of thumb, a doubling in “bond king” assets under management has been associated with a 10-20% decline in achieved alpha. As a result, historically a “bond king” with a smaller asset base has outperformed a “bond king” with a larger asset base. For investors seeking the possible beauty of “bond king” alpha, the trade-off between size and alpha suggests that small is beautiful.

Overview

  • A “bond king” is a fixed income portfolio manager perceived to be highly skilled
  • A “bond king” is assumed to have the talent necessary to “beat the market”, to produce “alpha”
  • There are very few “bond kings” at any given time
  • Empirically “bond king” fund alpha has declined as assets under management have increased
  • An abundance of “bond king” skill does not increase the size of the universe of mispriced securities
  • As a result, “bond kings” perform best when they manage a relatively small asset base
  • A “bond king” with a “smaller” asset base may outperform a “bond king” with a “larger” asset base
  • Historically, a doubling in assets under management led to a 10-20% reduction in “alpha”

The Historical Relationship Between “Bond King” Fund Size And Fund “Alpha”

  • There are currently two “bond kings”: Bill Gross and Jeffrey Gundlach
  • Historically, the “alpha” of Gross’ PIMCO Total Return Bond Fund declined as assets rose
  • Historically, the “alpha” of Gundlach’s DoubleLine Total Return Bond Fund declined as assets rose
  • The negative asset size-alpha trade-off may reflect too much capital chasing too few opportunities

Bond King Alpha

Matching Current “Bond King” Fund Size With Possible Future “Alpha”

  • Naïve extrapolation of the historical relationship between fund size and one year “alpha” suggests
  • Bill Gross’ new “unconstrained” bond fund could have an “alpha” of about 10%
  • Jeffrey Gundlach’s fund alpha could be about 3%
  • Bill Gross’ “old fund” might have an alpha of about 90 basis points

Bond King Alpha

Building Blocks: Historical Performance Of The DoubleLine Total Return Bond Fund

  • Since inception, the DoubleLine Total Return Bond Fund has outperformed “the market”
  • The outperformance is widely seen as a reflection of “bond king” portfolio manager skill
  • This performance has caught the attention of many investors

Bond King Alpha

Building Blocks: Historical Assets Under Management Of The DoubleLine Total Return Bond Fund

  • Many investors are aware of the performance of the DoubleLine Total Return Bond Fund
  • This awareness has lead to an increase in fund assets under management
  • At the end of August 2014, assets under management were approximately $35 billion

Bond King Alpha

Building Blocks: Historical Relationship Between Fund Size And Fund “Alpha”

  • Should there be a positive, a negative or no relationship between fund alpha and fund asset size?
  • Historically, the greater the assets under management the lower the “alpha” of DoubleLine Total Return Bond Fund Class I (MUTF:DBLTX)
  • This may be a historical curiosity or a reflection of the scarcity of mispriced assets relative to fund size
  • Historical relationships may not be stable, but there is only one history and one historical relationship

Bond King Alpha

Building Blocks: Historical Relationship Between Fund Size And Fund “Alpha”

  • Historically, the greater the assets under management the lower the “alpha” of PIMCO Total Return Fund Institutional Class (MUTF:PTTRX)
  • This may be a historical curiosity or a reflection of the scarcity of mispriced assets relative to fund size
  • Curiously, investor flight from PTTRX could improve its “alpha” potential

Bond King Alpha

Building Blocks: Historical Assets Under Management Of The PIMCO Total Return Bond Fund

  • Since April 2010, the size of the PIMCO Total Return Bond Fund has declined
  • Reasons for the decline in fund assets are varied including
  • Perceived challenging performance, and
  • An awareness of alternative investment opportunities

Bond King Alpha

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