When running an ETF for the first time, it’s only natural for portfolio managers to want to really satisfy investors – even if their performance isn’t au naturale. But PIMCO’s decision to use performance-enhancing maneuvers to puff up the size of its bond ETF in the first months of its launch has landed the firm a $20 million settlement with the Securities and Exchange Commission.
When PIMCO launched its much-ballyhooed BOND ETF back in early 2012, investors were excited. Bill Gross, once a critic of ETFs, was now ushering in a new era at the massive bond firm he co-founded. BOND, as the ETF was called, was designed to mirror Gross’s famed Total Return Fund.
Performance out of the gate was impressive. As CNNMoney reported in April 2012, a month after its launch: “Since its March 1 debut, the ETF has also outperformed its major competitors, gaining 1.7% compared with the modest declines suffered by index-based Vanguard's Total Bond Market ETF and BlackRock's iShares Barclays Aggregate Bond ETF.”
But the SEC says that BOND’s impressive premiere was buoyed by a strategy of buying up cheap odd lots – irregularly sized bundles of bonds that portfolio managers trade at a discount – and at the end of the day valuing them as if they were ordinary, full-priced round lots. That had the effect of boosting total net asset value and thus the ETF's overall performance in its crucial first few months.
Though some in the industry call it a regular practice, the feds aren’t too happy with it.
According to the SEC, the strategy contributed 54 percent to the ETF’s cumulative returns in the month after its launch, 30 percent the next month, and around 20 percent for the following two months. “The firm has enhanced its policies and procedures relating to valuation of smaller-sized positions and performance attribution disclosure,” PIMCO said in a statement.
The juicy quotes included by regulators in the settlement make it clear the strategy wasn’t accidental. Immediately prior to the fund’s launch, the head of PIMCO’s Structured Products desk offered the strategy as a way to help inflate the ETF’s returns: “We can find you several odd lot positions in the coming days that trade well below round lot levels and therefore pricing marks which will help with performance out of the gate.”
Three days after the launch of the fund, the ETF’s portfolio manager sent around a handwritten note – handwritten! – asking traders: “Today – ASAP – within the next 2 hours – find 1-2 million bonds in your area that are 2 points or more cheap to how they would be marked by pricing services at close tonight.”
There were immediate rewards for those who did so. According to the settlement, some of the traders who executed the odd lot strategy received “gold stars” from management – bonuses at $1,000 a pop for strong performers.
Internal compliance staff at PIMCO evidently issued notices to traders about the effect of the pricing strategy on net asset value, but their concerns were brushed aside, according to the settlement.
Others in the industry also argue that the odd lot pricing maneuver isn’t so odd. “This practice may strike outside observers as lax, but it is how the mutual fund business has long worked,” Paul Amery, an industry commentator told the FT soon after the regulatory probe emerged in September, 2014 – the same month Gross left PIMCO for rival Janus. Amery continued: “These have been industry-wide practices for years.”
It may not be precisely kosher, and investors may be let down when performance later sags, but hey! Lots of portfolio managers do it!
The SEC doesn't name any names and PIMCO neither admits nor denies the findings. We at Dealbreaker are racking our brains to figure out who might have been the one pushing the odd lots strategy to boost performance – someone at PIMCO at the time who was fond of handwritten notes and lucrative bond-trading strategies. Stay tuned for updates.