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2014 Q1 Market Update
04/10/2014

State of the Markets

In the first three months of the new year, stock and bond markets experienced a series of small up and down moves as investors caught their breath from 2013 and waited for trends to develop. Bonds recovered somewhat from a tough 2013 while stocks – locally and around the world – reacted to economic news, central banks guidance, and geopolitical tensions. When all was said and done, most major asset classes eked out a modest but positive gain, including the U.S. stock market, which closed just below an all-time high.

The total returns for major asset classes are below.

2014.04.10 Perf Table

Two stories recently in the news captivated the attention of both investors and the media. We believe neither story is as important as headlines would lead you to believe, but they do have bearing on the markets in general and our clients’ accounts in particular, so we will address them below.

Headline: Bill Gross is a Demanding Boss

Reporting on markets and companies day after day must get boring, so it is no surprise the financial media loves a good “how the mighty have fallen” story. They found one recently in Bill Gross.

Bill Gross is Chief Investment Officer at PIMCO, a firm he co-founded in 1971 that currently manages close to $2 trillion in assets. More importantly, he is the principal manager of the PIMCO Total Return Fund – a core bond fund in most of our portfolios.

While Bill Gross is an icon in the industry and has been for decades, this chapter of the story begins in January when Mohamed El-Erian, his co-CIO and heir apparent (Gross is 69 and El-Erian 55) resigned. In February, an article in the Wall Street Journal speculated that the resignation was due to growing friction between them, which included some indiscreet shouting matches and the occasional curse word. The main takeaways from the Wall Street Journal article (and many that followed) are that Bill Gross is a demanding boss, does not suffer fools, works extremely hard for his clients, and expects his team to do the same. Oh, and he can be grumpy at times – traits which are shared by many successful investors, entrepreneurs and managers.

El-Erian’s departure, questions about the culture of the firm, and a patch of poor performance has led many to question Gross’s ability to steer the $236 billion Total Return Fund. Rather than focusing on these “noisy” issues we prefer to look at Gross’s exceptional long-term track record.

2014.04.10 PIMCO Alpha

 The chart above illustrates just how exceptional that track record is by comparing the rolling three-year returns of the PIMCO Total Return fund to its relevant benchmark – the Barclays Aggregate Bond Market Index – over a 23 year time period. Every month begins a new three year period, so there are 284 total periods of comparison. In each three-year period that Total Return’s performance matches the index, the blue box falls on the line. When Total Return outperforms the index the blue box is above the line and in underperforming periods the box is below the line.

When we look at that chart we see a manager with a superior long-term track record. In 274 of the 284 three year periods, Gross beat his benchmark handily (a batting average of 0.965), and did so with minimal additional risk. His results are both consistent and persistent – a rare find in investment managers.

Is Bill Gross hard to work for? Sure. Is he working hard for his clients? You bet!

Headline: The Stock Market is Rigged!?

Michael Lewis is a wonderful author (one of my favorites) who has written many insightful books. The Big Short, The Blind Side and Money Ball are some of his most popular titles. His new book, Flash Boys, details the mysterious world of high frequency trading and its effect on the stock market. When interviewed recently on 60 Minutes, Lewis proclaimed “the stock market is rigged.”

To his credit, Lewis is shining light on an area of the stock market that is little understood, ripe for manipulation, and in need of greater regulation. We agree that trader’s use of super-fast fiber optic connections and high-speed trading algorithms to gain an unfair advantage over their competition is a problem that needs to be addressed. (An intelligent and detailed description of the issues can be found here. However, this hyperbolic statement, which will certainly sell some books and generate media buzz, oversimplifies a very complex issue. The unsophisticated investor, who probably won’t read the book but may remember the sound bite, is likely to draw the wrong conclusion and lose faith in a system that in aggregate serves them quite well.

The history of markets is rife with examples of traders trying to gain unfair advantages. Those advantages (and any accompanying profits) are often transitory because they either get arbitraged away by other traders replicating the advantage, or regulators step in to level the playing field. The stock market, which is highly regulated, evolves over time and becomes increasingly efficient. This, in turn, makes buying and selling securities cheaper and easier. I’ve addressed this remarkable efficiency in a previous commentary – Public Markets: the Good, the Bad, and the Ugly.

At the end of the day, an individual wouldn’t have a fighting chance trying to out-trade a hedge fund or investment bank, and shouldn’t even try. However, hedge funds and investments banks trying to out-trade each other reduces the cost of buying and selling shares for the rest of us, which ultimately benefits long-term investors. Once the problems associated with high frequency trading are fixed, the markets will be more stable and fairer, and then the countdown will begin until the next headline grabbing wrinkle needs to be ironed out.

Conclusion

Markets aren’t perfect and neither are people, and while the headlines inform our investment process, they but do not necessarily change it.