Bond investing isn’t about forecasting
The best way to sell anything is to tell a story — and bond funds are no exception to this rule. When you talk to bond-fund managers, they love to talk about their thesis, or their strategy — some grand vision of the world which, they hope, you will find compelling. If you do find it compelling, then you’re much more likely to invest your money with them.
Why you would behave in such a manner is simple: if the manager is right about where the world is headed, then, goes the theory, that manager is going to outperform and make lots of money.
Similarly, if a bond fund starts underperforming, then the storytellers tend immediately to jump on his grand pronouncements about the state of the world, because his big macro view was surely the thing to blame.
Paul Krugman, for instance, wrote four separate posts devoted to the thesis that the fall of Bill Gross is in large part a function of Gross being wrong (and Krugman being right) about interest-rate behavior in a liquidity-trap environment. Joe Weisenthal agrees: he says that Gross’s worldview, circa 2011 or so, “ended up costing Gross his role in the company he created”.
Even in the wake of Gross’s departure, his macro view continues to cast a long shadow of Pimco. Landon Thomas, for instance, spent over a thousand words on Thursday examining whether it’s smart for Pimco to retain Gross’s “new neutral” thesis:
Pimco’s new management team is doubling down on their departed leader’s economic mantra. And in so doing they are making the case that the Pimco bond funds that have made investments based on this economic approach — with some performing better than others — will not soon change their strategy.
Look a bit more closely, however, and things don’t seem to add up. For one thing, “some performing better than others” is the understatement of the year. Sam Ro put it rather better, I think, in his headline: “The Dan Ivascyn Chart Is A Mirror Image Of The Bill Gross Chart”. Ivascyn is the man who’s taking over from Gross as Pimco CIO, and he’s done spectacularly well (in contrast to Gross) investing off what is nominally exactly the same macroeconomic outlook thesis.
And when Thomas says of the “new neutral” thesis that it “never really took off until Mr. Gross pitched it at an investor conference while wearing sunglasses,” he more or less admits that it has more salience as a meme than as a driver of investment returns.
The fact is that in reality, if you’re a fund manager, your big macro investment outlook is much more important in terms of putting together a story — in terms of marketing, broadly — than it is in terms of generating alpha. Just look at the latest WSJ story on Pimco outflows: the Austin Fire Fighters Relief and Retirement Fund took five minutes to decide to move their $80 million to State Street. Why?
The Austin fund’s officials weren’t swayed by Pimco’s multiple attempts to reassure them that it would move past the current turmoil, Mr. Stefka said, adding that he had been a fan of Mr. Gross’s newsletter.
The newsletter — a marketing device which has zero bearing on returns.
People who understand the bond market understand that making money in bonds is hard, and has very little to do with your big macro theses, or what you write in your newsletters. In order to be a successful bond investor, you need to be able to navigate multiple moving parts at once, any one of which can trip you up. The macro outlook is one of them. But the macro outlook is just one of many different factors which have a bearing on interest rates. And “rates”, in turn, are not just one simple variable: there are hundreds of points on any yield curve, and at any given point in time there’s a good chance that many of them will be moving in opposite directions.
But rates are just the start. On top of rates you find credit: again, there are different credit spreads at different points in the yield curve, which can move away from or towards each other — and then within the credit universe there are thousands of individual credits, some of which are widening and some of which are tightening.
Then there’s the choice, in both rates and credit, between buying more-liquid derivatives or less-liquid bonds. And if you buy bonds, do you buy the more-liquid benchmark issues, or less-liquid off-the-run issues.
And then, once you’ve bought, what do you do? Is this a hold-to-maturity investment, or is it a trade? If it’s a trade, then how do you expect to unwind it? Especially if you’re running a large bond fund, how do you unload a significant quantity of bonds into a highly illiquid market? Or do you instead try to hedge your position, imperfectly, in the derivatives market?
There’s more, of course, so much more: what about foreign-currency bonds, or convertible bonds, or distressed debt? If you buy corporate debt, or mortgage-based debt, how and when should you litigate? If you’re buying secured debt, how do you analyze the underlying cashflows? If you’re buying municipal debt, how do you analyze the political risks?
And so on, and so on, and so on. Bond investing involves making thousands of fine-grained decisions, all of which add up. You can’t simply come up with some big macro thesis, press a button, and go play golf. Your bonds are constantly maturing, constantly throwing off coupon payments — and therefore you are constantly having to reinvest cash. You can’t ever stop, or take a breather.
This is one reason why I would never invest in Bill Gross’s new fund at Janus, which so far seems to consist of just him and one trader. Gross is a true bond-market savant, but he’s old — he’s 70, now — and he no longer has thousands of employees to whom he can outsource the fine-grained work of security selection and the like. He will go down in history as probably the greatest bond investor of all time, but the Bill Gross era is over, now, and frankly he should have retired, rather than attempting this desperate final act.
And this is also why I’m hesitant to draw simple connections between Gross’s stated macro outlook, on the one hand, and his fund’s returns, on the other. The futurology part of any bond investor’s job is always the most interesting bit as far as journalists are concerned. But it’s generally not the bit which really makes the difference between success and failure.