Ryan Blute, who leads PIMCO’s Global Wealth Management team in EMEA, answers questions about the global integration of PIMCO’s ETF business, the benefits of ETFs broadly, and the important differences between passive equity and active bond management.
Q. Why is PIMCO now taking on the full promotion and distribution of your EMEA-domiciled UCITS ETFs?
A. The time is right. We have a 10-year history successfully managing ETFs in EMEA and a suite of solutions that make a compelling complement to our more well-known mutual fund offering. But now we see an opportunity to integrate and globalize our ETF business, putting the whole effort on an equal strategic footing. We see a burgeoning opportunity across the world in ETFs, especially in fixed income, and particularly in EMEA, the second largest region for ETFs after the U.S.
We are a global firm with a global vision for our ETFs that we are eager to execute across regions and channels, with an integrated strategy across products, capital markets, marketing and sales. Just to give you some context on the size of our ETF business, we manage $30 billion in ETFs across several geographies and we’re among the largest active fixed income ETF managers in the world.1 If we look only at our UCITS ETFs, today we are the 6th largest manager of fixed income ETFs in Europe and manage the largest two actively managed ETFs.2
Q. How should investors and advisors think about your ETF initiative in the context of PIMCO more broadly?
A. They should understand that we are a high performance active fixed income manager, and that we are vehicle-agnostic. We are a leader in global active fixed income and have a long track record of almost 50 years in the space. We manage client assets across the fixed income universe and in virtually every structure available – from private funds, separate accounts, closed end funds, model portfolios, mutual funds and ETFs. Each structure has different and distinct benefits for investors, some allow for greater illiquidity, others offer more investment flexibility, and some are just more familiar to clients. The ETF vehicle itself has a number of obvious attractions: It trades efficiently on an open exchange, offers greater levels of transparency in its holdings, is priced continuously throughout the day, offers a single “clean” share class, no minimum or additional costs, and provides an intuitive way for investors to gain instant, diversified allocations. Ultimately, we want to deliver our fixed income expertise in whatever form makes the most sense for our clients.
Q. What about those who say that ETFs are synonymous with passive? How does that align with your active management focus?
A. ETFs are a vehicle, not a strategy. It’s easy to forget that. Many assume that ETFs are by nature or by definition passive. And while it’s undeniable that the vast majority of ETF flows go into passively-managed products, and specifically passive equities, it’s factually wrong to claim that ETFs = passive. Also, with equities, it’s easier to understand why investors have begun to default to passive ETFs. In a study that we conducted in the U.S., we found that over the past 10 years, the median active equity manager underperformed its passive peer by approximately 90 basis points annualized – and their stated benchmarks by 110 bps. Given that level of underperformance, the inclination to allocate to passive equities may be the only rational move for most.
But it’s different with fixed income. Our research shows that in bonds the active versus passive argument is almost diametrically opposite that of equities: Active managers outperformed their passive peers over the last decade in aggregate by 47 basis points. That’s why our advice to investors is don’t be mechanically passive in fixed income. In other words, we suggest that investors take thought before allocating to passive fixed income ETFs on the same premise, or with the same conviction, that they have historically allocated to passive equities. Simply put, bonds are different, and investors should consider the costs of inadvertent or kneejerk allocations to passive fixed income.
Q. What is it that makes fixed income so different from equities, when it comes to active management?
A. Take one obvious example: While stock indices are weighted by market capitalization, bond indices give greater weight to entities with the most debt outstanding. That means passive fixed income investors are lending more money to the most indebted issuers.
But a proper response requires the use of three distinct lenses: whether you look at the buyer base, the benchmarks, or the bond markets themselves – fixed income tends to provide richer ground for active managers to outperform compared to equities.
First of all, over half of investors in fixed income, including sovereign central banks and insurers, are not typically investing to maximize total return; their focus may be on liability matching or supporting currency valuations. Then there’s the nature of bond indices themselves, which are fundamentally different from equities. Replicating them efficiently is a totally different undertaking. They’re generally far larger than most equity benchmarks – the Barclays Global Aggregate Index has over 10,000 underlying securities, the S&P 500 just that many. Also, those fixed income securities are usually less liquid, and the index has turnover that’s almost 40 times that of the S&P 500. The idea of passively “replicating” that many issues with their rate of change, and doing so with very low tracking error, is exceptionally difficult. That’s why passive fixed income ETFs almost always require some form of compromise with the index, via sampling or optimization, to try and reasonably capture the index characteristics. And even then these passive bond funds also tend to operate with higher rebalancing and trading costs than equities. And finally, the limitations of any established bond index can radically limit the opportunity set. Active managers have far more freedom to tap a wider array of sectors and geographies in their search for alpha.
Three Lenses on the Opportunity for Active Bond Management
In general, the marketplace for bonds is far less efficient than stocks. Equities are traded in milliseconds on public exchanges, while bonds are still traded largely over the counter, slowly and in large blocks. Where equities are highly standardized and perpetual, bonds are far more idiosyncratic in their terms, and with finite, often short, lives. For example, new issues of bonds (the equivalent of IPOs) are frequent, constituting about 20% of the U.S. corporate bond market each year versus 1% for US equities.
All of these factors may give active managers a greater opportunity to outperform in fixed income than in equities. And in bonds, where overall returns may be modest relative to equities, that outperformance could have outsize relevance for investors.
Q. It sounds like you have no tolerance for passive fixed income in your ETF line-up. Is that right?
A. That’s not entirely true. There are some areas of fixed income that can offer attractive embedded returns. In those instances we may look to capture those in the most efficient and intelligent way we can – whether you call it “smart” passive or better beta.
For example high yield bonds with maturities shorter than five years may have advantages over those with longer maturities – they have less spread duration and so tend to be relatively defensive in an equity downturn. They have also historically provided returns on par with equities but at about half the volatility. And choosing an index with a 0-5 year maturity range rather than 1-5 allows us to hold bonds to maturity, avoiding selling at year one and the accompanying costly transaction costs. When we think about “smart” passive indexing, we are not as focused on minimizing short-term tracking error as we are other objectives, such as liquidity, transaction costs and portfolio turnover.
There’s a similar argument in emerging markets, and in particular EM local debt. For a variety of reasons, including illiquidity and high transaction costs, generic passive EM debt exposure provides returns that are often meaningfully less than index returns. But we believe we can improve on that. One case in point: the JP Morgan GBI-EM benchmark (the most common benchmark for EM local accounts) assumes zero taxes. Yet, as an example, the government of Indonesia (10% of the benchmark) actually extracts 10% withholding taxes from investors. In that instance we can utilize various strategies, including offshore issuance, to minimize or eliminate the tax impact of investing in emerging markets with minimal tracking error. So in general, with respect to the active versus passive debate in fixed income ETFs, our motto may be: “active where it matters, passive where it saves.”
Q. How would you characterize your offering to the market? What has driven the design of your suite of ETFs?
A. Our suite of ETFs runs from the ultrashort bond or “enhanced cash” category out to the highest yielding segment of emerging market local debt. Along that continuum we offer investment grade covered bonds (with its “dual recourse” character a compelling, higher returning alternative to ultra-safe European government debt) out to investment grade U.S. and European corporate debt. In certain of these areas, like investment grade bonds, we think active management can offer the best solution. In a handful of categories where “smart” passive investing may potentially deliver “better beta,” including U.S. HY, European HY, and emerging market debt, we use that approach.
But across that full spectrum of strategies we are leveraging the resources, investment process and expertise of the entire PIMCO team. At the end of the day, we are seeking to deliver a suite of ETFs that enable investors to meet their specific risk and return goals across the fixed income opportunity set, marrying PIMCO’s fixed income expertise to the ease and efficiency of the ETF vehicle.