PIMCO And Derivatives: Not A New Topic

PIMCO: Two Questions on Fixed Income from the Mailbag by David Merkel CFA of The Aleph Blog

From my readers:

What are your thoughts on Pimco’s new strategy for its flagship fund?

This concerns me because its one of the few “safe” funds in my company’s 401k plan.

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I haven’t heard anyone critique this and thought you’d be the best that I know of.

It seems to me that its a disproportional risk. And that due to its size could potentially cause problems.


This is not a new problem with Pimco.  You can review these two articles here:

Pimco has always used a lot of derivatives, though for marketing reasons some of their funds have fewer derivatives, even as Pimco tries to follow the same strategies.  You can view this three ways:

  • It hasn’t had horrible effects in the past, so why worry now?
  • We haven’t had the market event that would test the limits of this strategy yet, but can it really get that bad?
  • Now that the bond market is more crowded, Pimco’s quantitative bond strategies have less punch.  They don’t have the same room to maneuver.  Like the London Whale, have they become the market?

I lean toward the last of these views.  When you manage so much money, it becomes difficult to wrench alpha out of the market because mispricings are limited, and it is difficult to keep your trades from moving the market.

You might want to split your “safe monies” in your 401(k) plan if you have other credible investments.  That said, the likelihood of a large disaster harming Pimco is small — but you could try to cover that risk by setting a relative stop loss where you would exit Pimco versus a similar maturity fund run by Vanguard.

Another letter:

I’m a fledgling portfolio manager and blog reader.  Would you care to comment on the bounce we’ve seen in Treasury rates this month? (28 bp on the 10-year month to date).  I just don’t get it.  I see global growth continuing to underwhelm, more monetary opiates out of Asia, persistent dovishness from the Fed and the arrival (?) of the Godot that has been ECB stimulus.  These circumstances plus ongoing geopolitical issues make me wonder why Treasury yields have not gone further down or at least held the line.  I know it might be mean reversion or a supply/demand phenomenon but do not feel qualified to say and would enjoy reading your perspective.

Separately, are you aware of any Readers’ Digest Condensed summaries of monetary policy in Europe since 2007?  My career is not so old and each time I read about their approach to sorcery I encounter yet another acronym of which I am ignorant.

Best and thank you!

Back when I was a corporate bond manager, and things were moving against me, I would do a few things:

  • Seek out contrary opinion, and see if there was something I was missing.
  • Go out to lunch for Chinese food, dragging my trading notebook, and a sheaf of research with me, and schmooze over the data while there was no Bloomberg terminal in front of me.

Now, my own current views are conflicted, because I view the global economy like you do.  There is no great growth anywhere.  Geopolitical events should lead to a Treasury rally, and sanctions should weaken growth prospects.  I’m still long a moderate amount of the iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT), for myself and clients — it is difficult to see too much of a bear market with monetary velocity so weak.

That said, my recent 2-part series on the shape of the yield curve suggested that the curve shape was the sort where we often get negative surprises.  Despite the Fed’s confident mutterings that amount to little more than “Trust us!” the Fed has never been in a situation like this one and does not have the vaguest idea as to what it is doing.  They are proceeding largely off of untested theories that so far haven’t done much good or bad, aside from allowing the US Government to finance its deficits cheaply, thus cheating savers who deserve a better return on their money.

This is my thought: the slightest hint of tightening coming sooner moves the forward yield curve up, particularly in the 3-5 year region of the curve, but extending to 2- and 10-year notes as well.  But the questions remain how well growth holds up, how sensitive will the economy be to higher interest rates, and whether banks start genuinely lending against their expanded liabilities.

Personally, I expect rates to go lower after further growth disappointments, but I could be wrong, very wrong, so don’t be too bold here — scale into positions as you see opportunity.

Full disclosure: long iShares Barclays 20+ Yr Treas.Bond (ETF) (NYSEARCA:TLT)

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.