By: Jay D. Franklin  |   Sept 9, 2011
 

Once again, Mr. Market has shown us that he does not play favorites, and nobody is above a serving of humble pie at his table. His latest victim is none other than the “bond king” Bill Gross. You may recall that earlier this year, as part of his “new normal” prediction of extended low economic growth and de-leveraging by consumers, Gross eliminated all his exposure to U.S. government holdings in the Pimco Total Return Fund. With a whopping $243 billion in the fund, this was not easily accomplished. Rather than dumping billions of bonds on the open market, Gross took on derivative positions (such as futures and swaps) to hedge away his interest rate and U.S. dollar risk on U.S. government bonds. It would be interesting to know who was on the other side of those bets. It could only have been a large institutional player such as Goldman Sachs.

For the calendar year of 2011, the bet did not work out too well for Total Return’s shareholders. The fund returned 4.16% compared to 7.84% for Barclay’s Aggregate Bond Index. It was ranked it was ranked in the 87th percentile in its category (Intermediate-Term Bond). To his credit, Gross owned up to his error by saying, “It was a mistake to bet so heavily against the price of U.S. government debt,”¹ the Financial Times reported. This may do little to assuage those investors who added $21.2 billion in new flows for Pimco Total Return during 2010 and year-to-date 7/30/2011 (estimated net flow from Morningstar Direct).

What are the lessons for investors?

1. Relying on economic forecasts as the basis of portfolio decisions can lead to heartbreak.
   
    
2. Even the most celebrated of pundits can be wrong, and more than once. Recall that on February 26th, 2009, Gross declared the death of equities. Since then, even with the recent downturn, the S&P 500 is up 61%. It is noteworthy that Mr. Gross’s guru grade from CXO Advisory is a below-average 46% (last updated in May of 2009).
   
    
3. Recent investors in the Pimco Total Return Fund should chalk up their underperformance to the tuition that Mr. Market never fails to extract from people who believe that some genius will deliver them high returns without high risk. Hopefully, they will learn that rather than trying to outsmart Mr. Market or beat him to a pulp, they should let Mr. Market work for them by owning a risk-appropriate portfolio of index funds, and pay no attention to the gurus.

To quote one of our favorite economists, Paul Samuelson, “I tell people [investing] should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

Update as of 3/6/2012:

It is certainly possible that some day Bill Gross’s prediction regarding U.S. government bonds will come true. His primary mistake might have been arriving too early to the trade and not being able to hold his bearish position. Mr. Market stayed irrational longer than he could stay solvent.  According to PIMCO.com, Total Return was 30% in government bonds (excluding short positions) as of 1/31/2012. So far, the portfolio restructuring appears to be working out: As of 2/29/2012, Total Return posted a year-to-date return of 2.83% compared to 0.85% for the Barclays Capital Aggregate Bond Index. Has the bond king returned to his throne? Only time will tell. Either way, it is not a bet that we would encourage investors to place.

¹ Bill Gross, Financial Times, “Pimco’s Gross rues US debt ‘mistake,’” August 29, 2011, Dan McCrum
 

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