Why active equity managers should be scared of Gundlach, Gross

If actively managed equity mutual fund managers aren’t shaking in their boots yet, maybe they should be, because bond superstars Bill Gross and Jeffrey Gundlach seem to have figured out this whole beating-the-stock-market thing.

Both Mr. Gross’ Pacific Investment Management Co. and Mr. Gundlach’s DoubleLine Capital have made pushes into actively managed equities in the last three or so years. But where Pimco has really shined, and DoubleLine is likely to, is with enhanced index funds.

These enhanced index funds combine alternatively weighted stock indexes, or so-called “smart” beta, with an absolute return fixed-income strategy managed by the bond gurus. The strategy gives the funds two potential sources of alpha that can produce returns that beat a vanilla stock benchmark.

So far, the strategy has been shooting the lights out, even though it’s largely gone unnoticed.
The $3.1 billion Pimco Fundamental IndexPlus Absolute Return Fund (PXTIX) has a five-year annualized return of 35.42% as of Nov. 21, far outpacing the S&P 500’s 20.17% annualized return and the 24.83% returns of the fundamentally weighted Research Affiliates index it uses as its foundation.

In fact, it ranks as the top-performing large-cap fund over that time period, according to Morningstar Inc.
This year, even with head winds facing the fixed-income portion of the strategy, the Pimco fund has a 31.71%, ahead of its underlying index’s 31.17% return and the S&P 500’s 28% return.

Those winds haven’t made much of a dent because the bond portion of the strategy is looking only to outperform cash, or zero at today’s interest rates, so Mr. Gross doesn’t have to take on excessive duration to generate a positive return.

DoubleLine just launched its first enhanced index fund, the DoubleLine Shiller Enhanced Cape Fund (DSENX), at the end of October, so it doesn’t have much of a track record yet. But, if you think the manager who’s added 300 basis points of alpha to the Barclays U.S. Aggregate benchmark over the past three years can beat cash, it’s a good bet he’s going to add a similar boost to the fund’s underlying index.

The Shiller Barclays CAPE U.S. Sector Index on which the DoubleLine fund is based hasn’t been around as long as the Research Affiliates fundamental indexes, but an exchange-traded note that tracks it is up 30.52% year-to-date, suggesting it has the same potential to beat the S&P 500.

The two alternatively weighted strategies actually are quite similar. They take different routes, but essentially each is looking for undervalued companies.

The Research Affiliates fundamental index looks at factors such as book value, cash flow and revenue to find companies that are likely to outperform.

The Shiller Barclays CAPE U.S. Sector Index uses the research of Nobel laureate Robert Shiller to determine the four sectors of the U.S. stock market that are most undervalued and invests across them equally.
It’s important to remember that even though the funds are managed primarily by bond gurus and invest in bonds (the indexes are bought through total return swaps), these are equity funds at heart and have equity risk attached to them.

The Pimco Fundamental IndexPlus Absolute Return Fund lost 43% in 2008, for instance.

Still, when it comes to beating stock benchmarks over a longer time frame, it seems like an adviser might be better off with a bond manager than a stock manager.