Bill Gross Sees ‘Much Less’ Alpha in Era of QE and Quant Trading
(Bloomberg) -- Think of it as a parting shot to anyone hoping to be the next king of bonds. Bill Gross, who defined his investing career by beating benchmarks, says the era of outperformance is largely over.
“There are things to look at that still exist in the market that can generate alpha, although the probabilities of generating historical alpha in the same way are much less than they were,” Gross, who retired on March 1 after a 48-year career in financial markets, said in an interview with Bloomberg Television in Newport Beach, California.
The culprits are many. Gross, 74, recounted how, during much of his four decades at Pacific Investment Management Co., investors could, and without any “brilliance,” make 30 to 40 basis points, or 0.3 to 0.4 percent, of “structural alpha” a year just by holding a bond as it rolled down to shorter maturities. Now, yields are much lower and the spreads between Treasuries of different maturities are razor thin. With quantitative easing and zero and negative interest rate policies, central banks “changed the nature of the game,” Gross said.
It’s also harder to find mispricings. Gross says he used to pounce when banks introduced new credit products because they inevitably were poorly understood and traded at discounts to intrinsic value. The first few years of mortgage bonds in the 1970s are an example.
“Investors basically wouldn’t touch them,” he said. “Our accounting department, they didn’t know how to segregate the principal and the interest, and there were complaints aplenty. I said, ‘Come on, get over it!’ because these things were so cheap. We got in early.”
Similarly, Pimco was a big buyer of Treasury futures in the 1980s. Clients heard “futures” and asked, “Is this like soybeans? Are you trading corn?” Gross recalled. As a result, the spreads between the cash and futures markets were unusually wide and created a “sort of riskless arbitrage.”
Gross put himself ahead by identifying opportunities to take risk outside the bonds in his benchmark and using the Pimco sales force to get clients comfortable with the approach. Over a 15-year period, Gross beat 96 percent of his peers. Eventually, other investors caught up and those products were added to the index.
Now, those opportunities are mostly gone, in part because of the advent of computer-driven systematic strategies that eliminate mispricings much faster. And banks, subject to more scrutiny and regulation since the financial crisis, aren’t creating many new instruments to trade.
“Markets are highly developed from the standpoint of a menu of either real or derivative types of products,” Gross said. “We’ve gone about as far as we can.”
Gross has felt the pain himself. It started while he was still running the Pimco Total Return Fund. Thanks to bad bets on monetary policy, Gross trailed most of his peers in 2011 and 2013. Clients started to pull money. Gross feuded with his partners and left the following year.
At his new firm, Janus Henderson Group Plc, Gross switched from pursuing relative return against a benchmark to a so-called unconstrained strategy with a very different objective: absolute return, or positive results no matter the market conditions. Instead of an index, Gross’s bogey was essentially cash.
Because an unconstrained investor can buy or sell almost any instrument, Gross no longer was reined in by the limits on risk-taking inherent in an index. Seeking a meaningful return over the fund’s 75 basis points in fees, he ranged widely in search of yield, used leverage and ended up making mistakes.
“At Pimco, that was very much of a positive, to be constrained, to be a measured risk taker, which I always said I was,” Gross said. “And so I became a risk taker, but not necessarily measured.”
These days, it’s fashionable to blame the chronic underperformance of active managers on the growth of passive products -- index and exchange-traded funds -- and quantitative strategies such as momentum and trend-following. Gross calls the debate “phony.”
What active managers really object to, he says, is the increasing pressure on fees. Back in the 1980s, ’90s and even 2000s, when bonds regularly produced double-digit annual returns, it was easier to charge 150 basis points. That’s impossible now that yields are so low. And Gross, with central banks struggling to fight off deflation, doesn’t see them going up significantly anytime soon.
©2019 Bloomberg L.P.