In December 2015, the Securities & Exchange Commission proposed new regulations on the use of derivatives by US registered investment companies. This article looks at the derivatives exposures of two large mutual funds.
The Pimco Total Return Fund has shrunk from the $290 billion of assets that it had when Bill Gross left it in 2013, but still is large today at $84 billion AUM. It tracks the investment grade Barclays US Aggregate Bond index, and is a big derivatives user, with positions in futures, over-the-counter credit default swaps, interest rate derivatives and foreign exchange derivatives.
The fund is a noteworthy seller of CDS protection, both to shift exposure away from its benchmark or to add leverage. In mid-2014, this notional exposure was $30 billion, or 13% of net asset value, and as of June 2016 had increased as a proportion of NAV to 15%, with a gross notional of $14 billion. The biggest bets at this date included going long Mexico sovereign default risk at $1.1 billion and adding some $6 billion of corporate bond exposure using the Markit iTraxx and CDX indices.1)Since publishing its holdings in June, Pimco has reduced its CDS positions, and in its third quarter report said that its positions were 6 per cent of NAV.
Perhaps more interesting than the CDS trades are the fund’s use of interest rate derivatives. At the end of June 2016, the Total Return Fund had a swap position with notional size of $50 billion, mostly a short position in dollar swaps. It has $46 billion notional in dollar swaptions, and a large position in short-term interest futures, with a notional of $100 billion (calculated using the SEC’s methodology).
In its September 2016 quarterly investment report, Pimco hints at the reason for these trades. The fund owns $34 billion of US Treasury bonds with duration of 8.6 years. Pimco calculates that the swaps, options and liquid rates products have a combined duration of 4.6 years, and by taking a short position Pimco reduces its overall US government-related duration to 4 years, which is where it chooses to be in relation to its benchmark.
In other words, Pimco uses the derivatives as a tool to adjust its duration in an attempt to find alpha (not particularly successfully it must be said). It presumably does this because the alternative, trading the underlying bonds to adjust their average duration, would be more costly.
Pimco has done slightly better by taking a bullish position on US inflation. In addition to a $13.4 billion position in Treasury Inflation-Protected Securities (TIPS), the fund has also sold $7.5 billion notional floors on the Bureau of Labor Statistics urban consumers price index. It’s essentially selling deflation bets in the belief that these are a free lunch.
In addition to the dollar trades there’s a $5 billion short position in low duration sterling swaps, and a $3 billion long position in Mexican interest rate swaps. These strategies weren’t so successful, and were described as a “detractor” in the fund’s last quarterly performance report.
Foreign exchange is another big part of the Total Return Fund’s derivatives activity. Using OTC forward contracts, in June 2016 the fund sold $24 billion of dollars into foreign currencies, and bought $34 billion of dollars in exchange for non-US currency, with a maturity mostly less than one year. According to the quarterly performance report, these are tactical adjustments to the currency mix of the underlying portfolio based on the fund’s economic forecast.
Pimco attempts to summarise the impact of all the derivatives on its portfolio duration in a table published quarterly. The table shows that the contribution of these products to duration is very different to the proportion of their notionals, which echoes the comments Pimco made in response to the SEC’s proposed derivative rules. It needs to be emphasised that duration only measures interest rate risk to first order. CDS and foreign exchange contracts are small contributors to duration but add significant other risks to the portfolio. However, aside from a ten-year tracking error figure of 2.3%, Pimco doesn’t provide any information on the non-interest rate risk of its strategies either on an absolute or relative basis.
Blackrock’s $29 billion Strategic Income Opportunities (BSIIX) tracks a customised combination of two benchmarks: the Barclays US Universal Bond index and the Merrill Lynch 3-month US treasury bill index.
The fund buys more CDS protection than it sells, with total notional of $3 billion, or 11% of NAV in June 2016. The biggest bets are short positions on South Africa and Philippines sovereign risk, and long positions on financials. The South African trade could be described as a hedge (the fund owns $1 billion of that country’s debt) while the Philippines trade is an outright short, consistent with the fund’s unconstrained approach.
In rates, the picture is murkier, partly because the fund tracks a custom benchmark that it doesn’t disclose. The fund has almost $9 billion in developed country swaps, mostly dollar, amounting to a curve trade where it receives short duration and goes short on long duration. Taken together with the fund’s futures and underlying bond holdings, this gives an overall duration of 1.3 years, according to Blackrock.
In addition to this, the fund has about $3.8 billion in emerging market interest rate swaps, including short positions on Mexican and Brazilian rates, and a Polish zloty curve trade.
These OTC swaps haven’t helped the fund. “Exposure to non-US interest rates…constrained returns”, according to Blackrock’s June 2016 fund summary. By year end, the fund had returned only 4.4% , lagging most of its peers according to Bloomberg.
Aside from a single headline duration number, Blackrock says very little about the impact of its derivatives on duration or other key risk parameters, although it does disclose a twice yearly breakdown of average derivative notionals in different asset classes.
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|1.||↑||Since publishing its holdings in June, Pimco has reduced its CDS positions, and in its third quarter report said that its positions were 6 per cent of NAV.|