How do you define “smart passive?” Why did you choose to make a distinction between “smart passive” vs. just “indexed or passive” ETFs?
Indexing, or passive portfolio management aimed at tracking a benchmark, differs significantly for fixed income exchange-traded funds (ETFs) vs. equity ETFs. Fixed income ETFs nearly always require some type of sampling or optimization even if their investment aim is to track an index. This is because fixed income indexes are typically designed to be market benchmarks but not tradable portfolios. They usually include many more securities than equity indexes, and the securities included are often less liquid, making for fewer opportunities to fully replicate the index and greater costs in doing so.
PIMCO’s active portfolio management expertise strongly influences how we think about and manage our index ETFs. We believe our Smart Passive approach to managing fixed income index ETFs should include smart:
- Index Selection and Design: smart passive fixed income investing begins with a smart index, which we determine is structurally sound and stable, suitable, scalable and specific.
- Portfolio Replication: a better portfolio replication method starts with matching key economic risk factors – such as duration, curve duration and credit spread duration – between the index and the ETF portfolio and focuses on liquidity, market access and minimization of transaction costs. Our portfolios are optimized to select securities that will represent the index with a minimal level of tracking error, while keeping transaction costs low.
- Portfolio Execution and Rebalancing: a disciplined approach to trading and multiple trading relationships are crucial for best execution and minimizing transaction costs.
How do you define “actively managed” ETFs?
No differently than we define actively managed mutual funds. From a portfolio management perspective there is really no difference in managing an active ETF other than certain requirements specific to the ETF vehicle, such as daily holdings disclosure. There are portfolio inflows and outflows once a day just as with mutual funds, and similarly we invest based on the portfolio guidelines and investment objectives. PIMCO Active ETFs offer investors access to PIMCO’s unique investment process in the ETF vehicle.
This investment process consists of longer-term, or secular, inputs and analysis that formulate the guardrails for our investments on behalf of our clients, and short-term, or cyclical, inputs that help set near-term portfolio strategy. PIMCO’s ongoing assessment of the state of the global economy and markets, region by region and sector by sector, at our quarterly firmwide economic forums is combined with rigorous analysis of individual issuer dynamics and careful scrutiny of the specific attributes of each security we buy.
What’s PIMCO’s internal credit rating system and how do you utilize it in managing PIMCO ETFs?
PIMCO’s internal credit screening process, which assigns a green, yellow or red light designation to each issuer, is implemented independent of ratings assigned by S&P, Moody’s or Fitch. While the rating agencies assign ratings at issuance and provide ongoing monitoring, they tend to be backward-looking when it comes to downgrading issues. The downgrade usually occurs once credit deterioration has already taken place. Credits are eliminated from consideration in PIMCO’s optimization process if they are classified as a red light credit or are illiquid.
What about premiums and discounts associated with fixed income ETFs, especially in the corporate and high yield bond markets?
Premiums and discounts can potentially be mitigated by having a liquid, tradable replicating basket. Cash creations can also help reduce premiums and discounts in the market as the authorized participants (APs) can deliver cash rather than bonds to the ETF manager, potentially reducing transaction costs to the AP and the spread on the ETF. The ability to do cash creations and get best execution in the bond market requires that the ETF manager has multiple trading relationships and in-depth knowledge of all fixed income sectors.
What is “liquidity tiering?” How could an investor enhance cash returns by liquidity tiering?
Liquidity tiering is a method of dividing liquid assets into distinct categories and investing each set in appropriate strategies in order to optimize the need for liquidity with the potential for return. For instance, an investor may choose to invest cash that may be necessary for immediate expenditures in a money market fund. However, by investing other assets that may be necessary for certain but non-immediate expenditures in a slightly longer duration enhanced cash strategy, investors may be able to achieve higher returns. And by moving slightly further out the yield curve into a short-term strategy for liquid assets set aside only for emergency outlays, an investor is likely to enhance returns further.
How are you able to build a diversified and cost-efficient portfolio of bonds? How do you effectively manage the transaction costs when buying individual bonds?
Building a well-diversified portfolio can be costly, and effectively managing transaction costs is more likely achievable by having a team of sector specialists. Investing in the bond market requires maintaining multiple trading partners across several broker-dealers in order to best obtain good execution, particularly for smaller lot sizes. The over-the-counter nature of the bond market makes bond pricing very opaque; it also means that more experienced participants who have significant and continuous presence may have greater purchasing power and ability to minimize bid-offer spreads in execution.