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David Braun, Managing Director, PIMCO: So, we’re often asked about the flaws of index construction in the bond world, and when you think about when you build a bond index, you’re by definition putting more bonds of the most indebted companies or issuers in there. So when you look at the Barclays Agg, the bellwether index that the majority of funds are benchmarked to, first you'll notice the treasury component of the index has increased significantly over the last ten years,

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because the US Treasury has been running deficits and issuing more treasuries.

So if you’re indexing to the Agg, you’re by definition lending more to the most indebted issuer, in this case, the treasury. Second, on the corporate side, one of the large components of the index, you’re by definition lending more to the companies that have more weight in the index.

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And I’d like to think about an analogy here. If you ran a bank, and you were the senior loan officer at a bank, and someone walked into your door and asked for a loan, and your first and primary question to them was, “how much existing debt do you have outstanding?”

And if they had a lot of debt outstanding, you’d give them a big loan. If they had a little debt, you’d give them a little loan, if they had no debt, you would give them no loan. That’s what you’re in essence doing when you’re replicating a bond index.

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You’re lending to the most indebted companies, and not lending to the lowly-indebted companies. We try to do almost the opposite of that. We’re trying to find the companies that there’s a strategic reason why they’re adding some leverage to their balance sheet and debt to their balance sheet, and we’re getting fairly paid for that.

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Oftentimes, the companies that are in the index have a structural advantage in that their bonds are in higher demand by index replicators

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and low active share, active managers who are kind of hugging the benchmark. That gives them a financing advantage where their spreads are lower. Their bonds are more well-known, their bonds are more well-covered, certain people have to buy them in order to reduce their tracking error, and their spreads are tighter. That leaves, hopefully, potentially wider spreads on the bonds that aren’t as covered, or an active bond manager can cultivate those spreads.

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There’s been a big movement and big debate in the ETF world and the bond side about active versus passive. We actually think a lot of the flow that’s going into passive has almost been inadvertent — where, as ETFs begin to rise in prominence, a lot of people, knee-jerk reaction, concluded it must be like equities, were passive is the way to go.

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If you look at the empirical data, PIMCO agrees, it’s been really hard for active equity managers to beat their median passive peer group.

On the other side, when you look at bonds, the data is different. Over two thirds of active managers have successfully beaten their passive median peer group.

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And a couple reasons why bonds are different in that case. The market’s just different, right? The equity market is incredibly transparent,

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much, much fewer issuers, the bond market is largely over the counter, the tens of thousands of issuers, and at the end of the day, that creates structural inefficiencies in the bond market, that a passive manager can’t cultivate, but an active manager can.

Second, if you look at the bond market, it’s over 100 trillion dollars globally, and roughly 50 percent of those bonds end up in the hands of non-economic investors.

Photographs of the President of the European Central Bank, Mario Draghi and Chairman of the U.S. Federal Reserve, Jerome Powell

And what I’m talking about there are central banks, who need to buy bonds to manage foreign currency reserves, or buying bonds as part of their quantitative easing programs,

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or asset liability management driven investors, who are buying a bond simply to defuse the liability, rather than buying and selling bonds in order to generate alpha.

So, the fact that 50 percent is being held in those hands creates an opportunity for us and the other 50 percent to extract alpha out of the market that’s left out there.

Disclosure

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including the risk that fixed income securities will decline in value because of changes in interest rates; the risk that fund shares could trade at prices other than the net asset value; and the risk that the manager's investment decisions might not produce the desired results. Management risk is the risk that the investment techniques and risk analyses applied by an active manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. Investors should consult their investment professional prior to making an investment decision.

Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. It is not possible to invest directly in an unmanaged index.

References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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