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August 1, 2012

PIMCO's Eyes Are Fixed on ETFs

By James Armstrong

With the current volatility of the equities markets, investors know they need to have exposure to bonds, but they often desire the ease and liquidity of equities, which can be provided by exchange-traded funds. Customers want fixed-income safety and stock convenience, which has driven PIMCO-the don of bonds-into the world of ETFs.

PIMCO started its ETF platform in 2009, and it now offers 19 exchange-traded funds. Six of those are actively managed, including the BOND fund, which launched at the end of February and is managed by PIMCO co-founder Bill Gross. That fund made headlines recently when it significantly outperformed the company's behemoth Total Return Mutual Fund.

Don Suskind, head of global ETF product management at PIMCO, said some clients prefer to use ETFs for fixed-income investments because they offer all the benefits of trading in the equities market-intraday liquidity, efficient price discovery, access through an exchange-plus they provide portfolios that are transparent.

Don Suskind

"If they have any questions about what's in the portfolio, they can go online and download it," Suskind said. "You can see exactly what's in the portfolio."

Still, there are challenges in taking a basket of fixed-income products and getting them to trade like a stock. Fixed-income ETFs, unlike most equity exchange-traded funds, aren't fully replicating. Bond indexes often have thousands of issues in them, so in tracking an index, an ETF might only hold half the number of issues in the index, sometimes as few as 3 percent.

The other problem is ETFs rely on the creation and redemption of fund shares in order to keep the vehicle's price in line with the price of its underlying assets. When an ETF tracks large-cap equities, there are plenty of arbitrageurs willing to buy and sell the underlying stocks and then trade the fund against someone looking for ETF liquidity.

With fixed-income ETFs, the underlying assets are frequently far less liquid, which is why PIMCO is often willing to take cash creations or redemptions of its funds, rather than ETF holders having to go through an authorized participant to help them cash in shares or get new ones issued.

"In our active ETFs, we may create and redeem in cash, which may improve trading quality for investors," Suskind said, though he stressed there was no hard and fast rule about when the company would be willing to do cash trades.

When it entered the ETF game, PIMCO's biggest draw was its long experience in fixed-income investing, but the company also made several hires with specific expertise in exchange-traded funds. For instance, the firm hired senior vice president and ETF strategist Natalie Zahradnik from iShares before the ETF giant was bought by BlackRock.

According to Zahradnik, the buyside might not always be in a position to maintain numerous sets of counterparties and go out and get competitive bids on individual bonds, so there is a real advantage to being able to trade fixed-income instruments in the form of an ETF.

And while some bond ETFs often trade at a premium or a discount, particularly when they are just launched, some of the PIMCO funds began trading at tight margins very quickly.

"We've had examples like BOND that came right out of the gate at extremely tight spreads," Zahradnik said. "It traded at a basis point or two consistently right from the beginning."

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