Bill Gross really knows how to manage an ETF

Since launching in March 2012, Gross’ PIMCO Total Return ETF has had an annualized return of 5.9%, about double the return of the Total Return mutual fund, which for a long time has been one of the most popular in the world and is the fund that the ETF was built to mimic.

There are a few potential explanations for this. One, Gross is, for some reason, just better at managing bonds in an ETF than a mutual fund. Who knew? Another possibility is that Gross has been cheating. The Securities and Exchange Commission is, apparently, concerned about the latter.

According to The Wall Street Journal, the SEC is looking into whether PIMCO inflated the price of bonds in its ETF portfolio in order to boost the performance of its new product. Around the time of the launch of the fund, the traders for the PIMCO ETF bought a bunch of mortgage bonds, and other “odd lot” (meaning small issue) bonds. The bonds were harder to trade than others, so PIMCO’s ETF was able to buy them at a discount. The WSJ says PIMCO paid $480,000 for a bunch of bonds for the fund that would pay back $500,000 plus interest.

Immediately after PIMCO bought the bonds, it brought in an outside consultant to evaluate how much the bonds should be worth. The outside consultant said they were worth $500,000. After all, that’s what the cover of the prospectus said the bonds were worth. And so PIMCO immediately wrote up the value of the bonds to $500,000, taking a $20,000 gain, even though it knew the most it could sell them for was $480,000. After all, that’s what they had just paid.

Why have an outside consultant—and not traders—evaluate the bonds? Why not have the traders value the bonds? After all, traders are buying and selling bonds every day. They should know what they are worth.

While that sounds logical, Wall Street has had problems letting traders value portfolios and investments in the past. There is a long history of traders hiding their losses by writing up the value of the investments in their trading book. Remember the London Whale.

And so Wall Street hands the job over to outside consultants—which sounds better, but can apparently get regulators concerned at times.

The bonds that PIMCO bought were trading at a discount because they were illiquid, according to the WSJ. There was nothing wrong with the bonds. The borrowers were still paying on time. As long as you held onto them, you were likely to get $500,000. They were just hard to trade, because they were in weird-sized bunches.

One way to solve the illiquidity problem was to group them together into, say, an ETF. And that’s what PIMCO did. Now, you could easily buy and sell portions of those bonds. And now that they were easy to trade, why shouldn’t they be worth what they were supposed to be worth—$500,000?

The bigger problem is that ETFs are growing rapidly and getting more and more complicated. ETFs look like stocks or bonds, or any other thing else average investors normally put their money in. But they are not. They are derivatives, investments structured to perform like something else. But they don’t always behave that way. Most of the time, they do a little bit worse than the thing they are supposed to mimic. Sometimes, but not often, they do better. And that’s odd, and explains why some people are suspicious of ETFs.

A few years ago, when PIMCO was dragging its feet about launching the ETF fund, some people thought it had to do with disclosure issues. Mutual funds report their holdings and performance every month. But ETFs have to report daily. People thought that Gross had no interest in letting everyone know what he was doing on a daily basis.

But the real problem may have been that Gross knew something about ETFs. He had the largest mutual fund at the time, with over $200 billion in assets, and he didn’t want anything to rival that, even if it was another PIMCO fund. Perhaps Gross didn’t want to launch an ETF because he knew he would be too good at it, and that eventually would cause him problems. Either way, it has.