Pimco is well-known as the world's largest bond fund. But how many people realise it is also the largest investor in commodities, with a portfolio dwarfing the more high-profile pension funds?
And according to one of the most widely used databases, Pimco's flagship fund has been the most successful general commodity fund over the last decade.
With more than $21 billion invested in Pimco's main Commodity Real Return Strategy Fund at the end of June, and another $4.7 billion in the newer Commodity Plus Fund, the California-based investment manager's holdings are far larger than public pension funds with more famous commodity programmes like California Public Employees' Retirement System (CalPERS), or PGGM and ABP in the Netherlands.
CalPERS had a little over $3 billion in commodity derivatives at the end of June. Most specialist commodity hedge funds had under $10 billion and in most cases less than $5 billion in assets under management.
Pimco has also been an important innovator. Its main Commodity Real Return Fund was launched in June 2002, well before commodities became popular with investors as a new asset class. The newer Commodity Plus Fund was launched in May 2010 to implement a more active approach to managing both the commodity portfolio and the underlying collateral of fixed income securities.
Despite its success as an innovator and asset-gatherer, Pimco's role has attracted little attention outside the small group of banks competing to act as counterparties for its swaps business (among the lead providers are Morgan Stanley, ANZ, Deutsche Bank and Barclays, according to Pimco's latest annual report).
Keeping a low-profile has served Pimco well, as the influence of investors on commodity prices has been controversial since oil and a host of other commodity prices spiked in 2007-2008. Institutions have been blamed by anti-poverty groups, development campaigners and some lawmakers for driving up fuel and food prices, prompting calls for stricter limits on their investments.
Yet Pimco's role deserves more attention. The fund manager has implemented a markedly different approach compared with many of its rivals, generating superior returns. Pimco has achieved significant positive returns over the last five years while the commodity programme at CalPERS, for example, lost money .
At a time when the under-performance of many commodity strategies is beginning to attract critical attention, Pimco's approach may become an attractive template for other fund managers to copy.
Pimco has also been one of the most active organisations lobbying the U.S. Commodity Futures Trading Commission (CFTC). Pimco representatives have attended dozens of meetings with CFTC commissioners and staff, according to the Commission's records.
Pimco has lobbied on position limits, account aggregation, pass-through hedging exemptions for swap dealers, the definition of major swap participants, and a host of other Dodd-Frank regulations affecting the largest investors.
In a lengthy and detailed submission in March 2011, Pimco questioned whether the CFTC had met the statutory tests to impose position limits and "(urged) the commission to clarify that the position limits will not apply to commodity index contracts."
In the debate on position limits and other rules, most attention has been levelled at the major investment banks, as well as industry associations, which are now contesting the position rules in court. But Pimco has been among the most intensive lobbyists, and its arguments deserve as least as much scrutiny.
The disappointing returns on many index-based strategies for investing in commodities are well known. But Pimco appears to have performed better than many of its peers. The main Commodity Real Return Strategy Fund has achieved an average annual return of 9.4 percent since 2002.
Pimco differs from many other investors in that it uses the Dow Jones-UBS Commodity Index rather than the more popular Standard and Poor's Goldman Sachs Commodity Index. The DJ-UBS index is more diversified and has a much smaller weighting towards petroleum, especially U.S. crude, where the persistent contango structure has been a major drag on returns.
Pimco has been able to outperform its benchmark because it has invested in inflation-linked bonds and other higher-yielding fixed income instruments, rather than just conventional Treasury bills, to collateralise its portfolio of commodity derivatives. The Real Return Fund has also increasingly sought to implement what it terms "structural alpha strategies".
According to the fund's marketing materials: "Structural alpha strategies seek to add value by taking advantage of identifiable economic factors that create patterns of risk premia, minimise negative roll yield, and provide other techniques in an attempt to generate returns that are incremental to a published index."
Pimco is keen to distinguish structural alpha from the conventional active management offered by hedge funds - which according to the fund manager can be "hit or miss."
Nonetheless, Pimco emphasises that it does not employ structural alpha strategies passively: "Pimco's approach is to implement multiple, concurrent structural alpha strategies using experienced judgment, proactively adjusting exposures based on the current and changing attractiveness of risk and return, just as we do with alpha strategies in bond portfolios."
In its submission to the CFTC, Pimco argued: "our passive commodity index mutual funds allow investors to invest in a diversified basket of commodities, without affecting or intending to affect or disrupt any particular market or commodity. For instance, our flagship commodity mutual fund provides inflation protection and portfolio diversification for over 750,000 American investors".
But the actual results suggest the fund has a good deal of discretion. The fact the fund has significantly outperformed its benchmark hints at the flexibility its managers have in asset allocation. "We actively managed both components of a commodities index investment - the commodities futures exposure and the underlying collateral" the fund explains in its quarterly investment review.
In the second quarter, for example, the fund outperformed its benchmark by selling WTI volatility. In the third quarter, Pimco aimed to boost returns by overweighting Brent versus copper to capitalise on Middle East instability, and by holding a long position in heating oil spreads to benefit from low inventories and the changing specification of the heating oil contract.
For investors who want an even more active approach, the newer Commodity Plus Strategy Fund offers an even more active approach to managing both the commodity derivatives portfolio and the bonds which collateralise them.
Pursuing structural alpha seems to have worked. Since the Commodity Real Return Strategy Fund was launched in June 2002, it has returned an average of 9.4 percent per year, compared with 5.0 percent on the benchmark DJ-UBS index, and just 2.6 percent per year for all the general commodity funds. On 3-year, 5-year and 10-year horizons, the Real Return Fund is ranked number 1 in the Lipper survey.
The question is whether this performance is due to skill and can be sustained in future, or whether it was just a symptom of the bull market between 2002 and 2008, and post-crash rebound in 2009 and 2010? Will it be sustained as traditional inefficiencies in the commodity markets are arbitraged away by the increased number of investors chasing them.
The fund's most consistent returns were all in the first five years. It has returned an average of 9.4 percent in the ten years since 2002, but just 1.7 percent in the last five. Big gains in 2007 (24 percent), 2009 (40 percent) and 2010 (24 percent) were largely offset by a massive loss in 2008 (43 percent) and a smaller one in 2011 (7.6 percent). In the first six months of 2012 the fund was essentially flat.
Most fund managers in most asset classes have struggled to produce consistent positive returns following the financial crisis.
But the falling returns, which have been mirrored across the commodity sector, raise questions about whether funds' long-only strategy will continue to work if prices stop rising and as the sector becomes more crowded. It is not clear the fund can generate enough structural alpha by exploiting market inefficiencies to offset the negative drag from the cost of carry.
In his controversial book "The Hedge Fund Mirage", author Simon Lack argued that most of the returns in the hedge fund sector have been generated by small, innovative funds, and most of the historic returns were generated when the sector itself was much smaller. Size has been the enemy of performance as the opportunities for outperformance have been competed away.
Pimco is not a hedge fund. But the question is whether something similar will now affect Pimco's commodity funds. As the volume of assets under management grows, and the total volume of commodity investment increases, can the previous returns be sustained?
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