Pimco Bet on Low Volatility Goes Beyond Bonds in New Neutral

Jun 20, 2014 10:21 am ET

(Updates Total Return performance in penultimate paragraph.)

June 20 (Bloomberg) -- Bill Gross is applying Pacific Investment Management Co.’s theory of the “new neutral” beyond bonds, wagering that volatility across markets will remain abnormally low.

“We sell insurance, basically, against price movements,” Gross, chief investment officer of Pimco, said in an interview yesterday in Chicago at Morningstar Inc.’s Investment Conference. “At Pimco, that’s what we’ve tried in the last four or five weeks.”

The wager on volatility by the $2 trillion asset manager is “part and parcel” of its outlook for the next three to five years, an era it calls the “new neutral,” Gross said. The outlook is characterized by low interest rates and lower, more stable global growth. Stocks and bonds will only return about 5 percent and 3 percent respectively, as any changes in Federal Reserve policy will be taken cautiously, the Newport Beach, California-based firm said in a report in May.

The firm’s money managers “all know all parts of the new neutral,” and incorporate it into their trading, Gross, 70, said. “Historically, Pimco has succeeded in selling volatility, and yes, it’s nice volatility’s come down.”

Pimco’s strategy has caused traders to speculate that the company was selling calls and puts on the Standard & Poor’s 500 Index in April and May in a bet that prices won’t spike or drop, and also amassed positions in interest-rate swaps to express the same view, according to four people who heard about the trades, all of whom asked not to be identified because they aren’t authorized to discuss them. Gross declined to discuss specific trades at Pimco.

Low Volatility

“People came into this year thinking we were on the verge of a breakout in economic data, it hasn’t happened and people realize Fed policy isn’t threatened anytime soon,” said David Schawel, a money manager at Square 1 Bank in Durham, North Carolina. “That’s a green light for low volatility to prevail.”

The trades are probably “less about compelling value and more about a belief that the path for credit risk is very low for the foreseeable future,” Schawel said. “The longer this benign environment drags on, the more people are willing to expect the status quo remains.”

The Chicago Board Options Exchange Volatility Index, which measures price swings in stocks, tumbled 12 percent on June 18 to close at 10.61, the lowest level since February 2007. This year’s high of 21.44 on Feb. 3 compares with a five-year average of 19.7.

S&P Record

Call options are derivative contracts that allow investors and traders to wager that the value of an underlying security will increase, and puts bet on a decline. The contracts give investors the right but not the obligation to buy or sell a security at a certain price.

The Standard & Poor’s 500 Index rose 0.2 percent at 10:02 a.m. in New York after closing at 1,959.48 yesterday, the highest ever. The gauge has risen from this year’s low of 1,742 in February. At an investor conference in May, Goldman Sachs Group Inc. President Gary Cohn blamed the reduction in trading on calm markets and the Fed’s efforts to hold down interest rates.

Hedge funds are betting the stock-market tranquility will be around for a while. Large speculators have added bets on lower volatility in the last two months, according to data from the Commodity Futures Trading Commission. They were net short about 73,300 contracts on VIX futures as of June 10, about the most since October, CTFC data show.

New Mexico

The historic lack of price swings is costing Saba Capital Management LP money. Saba’s credit fund fell 1.7 percent this year through May and assets in the strategy have shrunk 23 percent to $2.7 billion since the start of December.

The investment committee of New Mexico’s public employees’ pension fund voted last week to pull $43.5 million from Saba, citing an inability to make money in the current low-volatility environment, said a person with knowledge of the decision, who asked not to be named because its internal discussions are private.

Saba isn’t alone in struggling. Funds run by Paul Tudor Jones, Brevan Howard Capital Management LP and Fortress Investment Group LLC are among those that have lost money this year.

New Neutral

Pimco’s bet on tranquil markets stemmed from its new thesis outlined on May 13 from the annual Secular Forum, which guides its investment philosophy for the next three to five years.

At the Secular Forum, Pimco’s money managers and analysts listen for two and a half days to “distinguished guest speakers,” who this year included Harvard University professor Carmen Reinhart and FiveThirtyEight.com founder Nate Silver, to establish their world view on global economies and markets. For the rest of the week, they turn that philosophy into trading strategies.

In the aftermath of the 2008 financial crisis, Pimco’s co- founder Gross and his former co-Chief Investment Officer Mohamed El-Erian popularized “the new normal” to describe an era of subdued returns, heightened government intervention and increasing clout for emerging nations in the global economy.

Refined View

Now, five years later, after El-Erian’s abrupt resignation in January, Gross refined that view. While the “new neutral” maintains an expectation for subpar returns, it’s a more stable outlook compared with Pimco’s previous forecast as the risks to the markets are lower. Generating returns is becoming increasingly difficult as central bank policies elevated prices on so-called risk assets, the report said.

Gross, who started the firm in 1971 with two other co- founders and has built one of the best long-term records in the industry, has struggled in the past year to stem record redemptions as his $229 billion Pimco Total Return Fund fell behind peers.

Total Return has returned 0.1 percent in the one month through June 19, beating 65 percent of competitors, according to data compiled by Bloomberg. While it’s gained 3.1 percent this year, it’s trailing 61 percent of rival funds.

The fund will again top its competition this year, Gross said in a Bloomberg Television interview last month, as it sticks to the front end of the yield curve, buys bonds maturing in five years to seven years, and focuses on high-yield debt and risk assets, “which will be not high-returning but basically stable and low-risk and low-volatility.”

--With assistance from Callie Bost in New York.