— Paul Amery's Blog

PIMCO’s odd lot

US fund manager PIMCO is apparently being investigated by the US regulator for valuing bonds in its Total Return ETF differently to the prices at which it bought them, providing a temporary boost to fund returns as a result.

“The inquiry comes amid escalating scrutiny by the SEC of whether investment funds are valuing assets accurately and fairly,” reports the Wall Street Journal.

In one sense this is hardly a story at all. In another it’s a very big issue. Why?

The reasons why PIMCO’s reported behaviour may not have breached standard market practice are the following.

First, unlike in the equity market, the liquidity of the bond you’re trading depends greatly on the size of the deal.

“On a typical [corporate] bond issue, the bid-offer spread on a US$1 million transaction might be 1 percent  of par value, but for a smaller order the spread might be 3 percent  or more,” a bond trader told me a couple of years ago.

Press reports suggest that PIMCO may have been buying odd lots of bonds (with wide bid-offer spreads) for its ETF and valuing them assuming more standard deal sizes, generating an apparent (though temporary) performance boost to the ETF. This assumes that the fund manager was able to buy its bonds on the “wrong” side of the spread: at or close to the bid price. Unusual, but possible, given PIMCO’s clout.

Second, mutual fund managers’ practices in valuing bonds vary widely and typically allow the managers a great deal of discretion. Yes, managers use external pricing services, but they often retain significant control over pricing policies.

PIMCO’s Total Return ETF prospectus tells us that “portfolio securities…are valued at market value. Market value is generally determined on the basis of last reported sales prices, or if no sales are reported, based on quotes obtained from a quotation reporting system, established market makers, or pricing services,” and that “securities…for which market quotes are not readily available are valued at fair value as determined in good faith by the Board of Trustees. The Board of Trustees has adopted methods for valuing securities and other assets in circumstances where market quotes are not readily available, and has delegated to PIMCO the responsibility for applying the valuation methods.”

So if your bond is relatively illiquid and has a 3% spread between bid and offer prices you have pretty free rein to value it anywhere within that spread, as long as your approach is consistent. This practice may strike outside observers as lax, but it’s how the mutual fund business has long worked.

In 2007, academics from the Mason School of Business published a prize-winning paper showing how the same corporate bonds are priced differently by different mutual fund groups. Some fund firms priced a bond based on secondary market bid prices, others based on the mid-point between bid and offer prices. Around a third of the firms (like PIMCO) refused to tie their pricing policies explicitly to bid or mid prices and instead referred to pricing on the basis of “fair value”, a concept affording substantial discretion to the fund managers.

The academics also produced evidence of return “smoothing”: those funds that had outperformed had a tendency to mark bonds at higher prices, while those that had underperformed tended to do the reverse.

Such smoothing basically cheats one or more of three constituent groups: existing, new, or redeeming fund investors, since someone is dealing at too favourable or too unfavourable a price. But according to the plentiful evidence supplied in the paper, this practice has been going on for years, and it’s not against the rules.

Unless the SEC’s enforcement policies have changed markedly (and I can’t find any evidence for this), I can’t see how it can nab PIMCO for its valuation practices, however loose the “fair value” pricing policy might sound, that have been industry practice for years, as long as the firm was acting consistently and in accordance with the prospectus language.

Cases where the regulator has brought enforcement action against a fund group have tended to involve much more dramatic overstatements of funds’ NAV than those reportedly involved in the PIMCO case.

On a deeper level, this story is of course quite alarming. It reminds us of how deeply illiquid large segments of the bond market really are, even with the recent near-zero levels of interest rates, and how we disguise that illiquidity by putting bonds into daily dealing mutual funds and ETFs and marketing them as more liquid than their constituents. This comment isn’t aimed at PIMCO, by the way.

There’s an irony here, as well. The SEC that’s reportedly investigating PIMCO for overoptimistic valuation policies in a bond fund was long set against reforms forcing money market funds–another type of mutual structure–to value their holdings at market prices, rather than at a notional (and often fictitious) $1 a share. But that’s another story.