Bubble Risk Is A Two-Way Street

Market bubbles are dangerous when they burst, but they’re no picnic for investors who make ill-timed bets that the party’s over. Just ask Pimco’s Bill Gross, manager of the Total Return Fund, the planet’s biggest bond fund. In February, he sold all the Treasuries in the fund and compounded the bet with derivatives. He now admits that it was a “mistake,” via The Wall Street Journal.

It’s easy to see why. Treasury prices have soared since February, which means that yields have dropped sharply. The yield on the benchmark 10-year Treasury Note, for instance, settled at 2.28% yesterday, down from as high as 3.75% at one point in February. As short-term rallies in Treasuries go, that’s about as potent as it gets. Thanks to ongoing economic challenges this year, the popularity of safe-haven Treasuries has soared… again.

Don’t be too hard on Gross, however. The view that Treasuries were overpriced was widespread earlier this year. Bubble talk was everywhere. And back in February it all sounded reasonable. But reasonable forecasts have a way of turning to dust at times as uncertainty roils the best laid plans of mice and men. One result is that so-called bubbles can roll on for longer than you think, which raises questions about definitions. What exactly is a bubble? No one really knows, or at least no one can provide a working definition in real time. Of course, it’s all obvious in hindsight.
Still, Pimco’s Total Return Fund got off relatively easy. Why? Gross kept a lid on his active management activity. Some might call that risk management. According to the Journal:

Over the past three months through Friday, the fund had a return of 0.16%, compared with a return of 2.78% for the benchmark Barclays Capital Aggregate Bond Index, according to data from Morningstar Inc.

Over the past month through Friday, the fund lost 0.56%, versus a gain of 2.01% for the benchmark.

The Total Return Fund has been adding to its Treasury positions since March, including a jump in July to 10% of its holdings, up from 8% in June. Overall, the fund now has net positive exposure to Treasurys for the first time in months. Relative to peer bond funds, the Pimco fund is still underweight Treasurys.

To be fair, Gross enjoys one of the best records among fixed-income managers, even after his “mistake.” But his ill-timed bet is a reminder that even the smartest of money men can and will stumble at times. The only question is how big the stumble will be?
The answer depends on many factors, starting with a manager’s willingness to hold portfolios that differ from the benchmark. In order to beat the benchmark, you have to move away from it. It’s also true that for those who mint market-beating results, the advantage is financed exclusively by those who made losing bets. In the middle, as always, is the benchmark. And after adjusting for the relatively higher expense of active management, the benchmark is likely to end up as slightly above average. That’s true for individual asset classes and for multi-asset class portfolios as well.
Skeptical? You’re not alone. The majority of the planet’s investors subscribe to the idea that great success awaits in active management. Nonetheless, you can safely anticipate that half of those who attempt to outguess Mr. Market will end up with below-average results. Why? It’s not for lack of opportunity. There are many so-called market anomalies waiting to be exploited, as catalogued in Expected Returns: An Investor’s Guide to Harvesting Market Rewards. The trouble, alas, lies with the investors.
No wonder that passive benchmarks remain competitive over time, as you can see in the regular updates posted on this site each month. (Here’s the July 31 tally, for instance. On that note, I’ll be posting the end-of-August results later this week.)
So, yes, bubbles can be grounds for minting alpha, but they can also be short cuts for trailing the market. As always, the devil’s in the details and any shortcomings are due to us. Granted, that’s an old story, but it’s also forever new.