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Win With Smaller ETFs

Written By Briton Ryle

Posted June 4, 2014

With thousands of investment funds available, analysts work hard to sift through the assortment to pick out those that offer the best return for your money. And their means of comparison are vast, using such metrics as sector, geographical market, investment strategy, and more.

But there is one other useful metric that can be used to anticipate a fund’s performance… its size. Over the shorter term, smaller ETFs tend to outperform their larger mutual fund counterparts.

This could make the new bond ETF about to be offered by DoubleLine Capital LP — the SPDR DoubleLine Total Return Tactical ETF — a very profitable fund to own, especially when comparing it to rival PIMCO funds.

Let’s follow this line of reasoning through and see just why some analysts are pinning high expectations on DoubleLine’s new ETF.

Comparing Fund Parents

The first indication we have that DoubleLine’s new Total Return Tactical ETF should be a stellar outperformer is found in the performance of its closest relative — the DoubleLine Total Return Bond Mutual Fund (DBLTX), which has “performed better than 95 percent of its peers during the past three years,” according to data compiled by Bloomberg.

Essentially, the new Total Return Tactical ETF will be, in general terms, just an exchanged-traded version of DoubleLine’s Total Return Bond Mutual Fund, promising a kind of “success by association.”

According to Yahoo! Finance, DL’s existing mutual fund posted annual total returns of 9.51% in 2011, 9.16% in 2012, 0.02% in 2013, and 3.1% year-to-date. This compares with PIMCO’s closest counterpart, the PIMCO Total Return Bond Mutual Fund (PTTRX), which posted annual total returns of 4.16% in 2011, 10.36% in 2012, -1.92% in 2013, and 2.05% YTD.

How do these funds rank within their category? Where PIMCO’s mutual fund ranks 48th (in three-year returns), 91st (in one-year returns), and 83rd (in YTD returns), DoubleLine’s mutual fund ranks 3rd, 20th, and 29th respectively.

The main reason DL’s mutual fund has been outperforming PIMCO’s is all about composition, duration and turnover.

The first feature that instantly catches our attention is the amount each fund holds in cash: where DoubleLine’s fund is almost fully invested in bonds with just 5.58% in cash, PIMCO’s fund is only half invested in bonds, with 46.76% in cash.

It seems PIMCO has been betting interest rates would rise faster, which hurts bond values, and has thus opted to keep a larger portion of its assets in cash. DL, on the other hand, has remained almost fully invested in bonds, counting on bond prices remaining strong, which has been the case so far.

Further on each fund’s composition, where PIMCO’s fund invests primarily in investment-grade bonds, with no more than about 10% invested in high yield bonds rated B or below, DL’s fund typically invests more than 50% of its assets in mortgage-backed securities, with up to as much as 33% in high-yield bonds rated B or below. This allows DoubleLine’s bond mutual fund to earn more income the PIMCO’s.

Their holdings duration is another important difference. Where PIMCO’s fund’s average maturity and duration are 6.04 and 5.37 years, DL’s fund averages 5.66 and 3.79 years, respectively. While each fund’s holdings are about the same in length of time to maturity (the time until bonds are paid back), their durations (the “weighted average of the time to each interest coupon and principal payment of a bond,” as explained by Morningstar) are much shorter in DL’s fund, allowing it to collect interest payments sooner, which are reinvested earlier.

Finally, there is each fund’s turnover rate, with DL’s low annual turnover of 25% being vastly calmer than PIMCO’s overactive 380% annual turnover. PIMCO’s high turnover activity may come from selling into bond rallies, which explains its high cash position. Unfortunately, this also takes the fund out of the bond market early, sacrificing further gains when bond rallies keep going.

All together, DL’s lower turnover, lower cash position, higher interest, and shorter duration between income payments allow it to ride each bond wave more fully.

Comparing ETF Offspring

Noting these main differences between the two rival bond mutual funds gives us an idea of how each fund’s ETF offshoots might compare. Since DoubleLine’s bond mutual fund has been outperforming PIMCO’s mutual fund as noted above, DL’s new ETF version should likewise outperform the ETF version of PIMCO’s fund: the PIMCO Total Return Bond ETF (NYSE: BOND).

Since February 29, 2012, PIMCO’s bond ETF has returned 14.7%, far better than its bond mutual fund’s total return of 8.7%, as tabulated by Bloomberg. The main reason for the ETF’s better performance is its smaller size.

“There are things you can do in a smaller fund that you can’t do in a larger fund,” explained Eric Jacobson, a Morningstar analyst.

For instance, PIMCO made greater use of non-agency and commercial-mortgage bonds last year, which boosted the yields of both its mutual fund and its related ETF. But because ETFs are more “nimble” and flexible with their investments, the ETF “boosted such holdings to about 12 percent of assets, compared with an increase to 7 percent in the mutual fund,” explained Jacobson. “They both were helped by those positions, but the ETF was helped by 80 basis points more than the mutual fund in 2013,” he compared.

In support of this, the annual holdings turnover of 449% in PIMCO’s bond ETF is higher than the 380% turnover in its related bond mutual fund, producing a greater effect on the smaller $3.3 billion ETF than on the larger $230 billion mutual fund.

Finally, there is the “tactical” element of DoubleLine’s new Total Return Tactical ETF, which permits additional flexibility to venture into areas PIMCO’s bond ETF does not. As in the case of DL’s bond mutual fund, its new ETF offspring will continue the legacy of heavy investments in mortgage-backed securities and high-yield bonds to the tune of 40% and 25%, respectively. DL’s ETF will also be dabbling in foreign currencies and emerging market bonds by as much as 15% and 25%, respectively.

Small and Nimble Wins the Day

If the performance of DoubleLine’s bond mutual fund over PIMCO’s bond mutual fund is any indication, DL’s new bond exchange-traded fund should outperform PIMCO’s BOND ETF based on each company’s fund structure and strategies.

But size is likewise a factor that mustn’t be overlooked. Where PIMCO’s smaller ETF has distinct advantages over its bulkier mutual fund, we should expect DoubleLine’s new ETF to fair all the better. Sometimes less is more.

Joseph Cafariello