AVA : Investment Analytics

I’ve sat by now for about ten years now, waiting for someone from the financial industry to point out what I am about to reveal. I meant to write about this but I kept forgeting.

I have to conclude that no one has written or spoken in the media about what I’m about to reveal because many simply are unaware of what I deem to be obvious. Others don’t want to go against their colleagues in the financial industry. But what these guys seem to forget is that their first loyalty should lie with the investment public.

I feel the need to point out what I feel to be very disturbing facts behind PIMCO’s Total Return Fund. In short, I feel the fees charged are excessive by any reasonable measure. And when you consider the size of the fund (being the largest mutual fund in the world) this should be further evidence that you can’t win with Wall Street.

The scary part is that you have some really large investors in this fund; investors that are supposed to be “sophisticated;” even investors with a fiduciary responsibility to their clients.

First of all, let me dish out my own personal opinion. Very rarely would I deem an investment in open-end investment-grade bond fund to be prudent from the standpoint of the cost structure. And you certainly aren’t receiving the type of asset and risk management services relative to the fees charged.

Support for my view can be found upon examination of PIMCO’s Total Return Fund, managed by Mr. Bill Gross, the highly touted bond fund manager. Historically, this fund has focused on managing mainly AAA and other investment grade bonds.

Generally speaking, managing investment grade bonds isn’t something particularly difficult for a professional bond manager to do. Granted, during the current economic catastrophe, this task is a bit more challenging. But what we are experiencing is extraordinarily rare. Gross’ fund has been charging excessive fees for many years. But the SEC allows it and other bond fund managers do the same, so we cannot place all the blame on him.

Now, the Total Return fund doesn’t manage exclusively AAA bonds. It does have some risky bonds as well, but the majority are investment grade. You can imagine the temptation to delve into more of these risky “junk” bonds when interest rates are low, so as to increase the returns. As such, Gross does this, as it is listed as a minor part of the investment strategy.

But again, Total Return is primarily for investment grade bonds. The problem is that under normal circumstances, investment grade bonds have very limited upside potential, unlike non-investment grade or junk bonds, which can pay off big. Of course, investment in junk bonds are highly risky and don’t offer the liquidity of investment grade bonds.

The point is that due to the limited upside in investment grade bond funds (since your returns come mainly in the form of dividends), the total fees should be very minimal in order to comply with any standards set forth by the financial regulatory authorities.

Let’s have a look at one of the many share classes of the Total Return Fund. The total (disclosed) fees are close to 2% (management and 12b-1 fees). Of course, these fees would vary depending on which share class you bought. But there are additional fees as well, such as ticket charges, but we do not know what these amount to because they’re not reported. You can be assured that once all fees have been accounted for, they come in at over 2% of your investment assets annually.

Okay so we have some fees that are typical of equity mutual funds. Of course, part of the problem is that mutual fund fees are excessive. In the end, the only real way to determine how much you’ve been nailed in fees is to look at your account and subtract what you started with from the current balance and do some simple math. Chances are, you will be looking at around 4 percent for the average equity mutual fund, no or no-load.

Of course if you contribute regularly to your mutual funds, it’s virtually impossible to determine these calculations. Mutual fund companies not only know this, they intentionally set it up this way (i.e. fail to provide you with complete and clear disclosure) so you won’t realize how terrible the funds are and how high the total fees really are.

The reality is that the SEC should require a detail and clear statement of fees so investors can determine if they are getting their money’s worth. I advise you not to hold your breath.

Let’s glance at the fees for the three most common share classes of Total Return. The total expense ratio is the combination of 12b-1, management fees and other fees. Once again, there are several other fees that are not included in the expense ratio.

PIMCO Total Return A PTTAX
Management Fee 0.25%
Total Expense Ratio:0.90%
Max 12b1 Fee:0.25%
Front End Sales Load:3.75%

YTD Performance as of 04/17/2009 2.08%
1 Year* 2.50%
3 Year* 6.16%
5 Year* 4.43%
10 Year* 5.94%

PIMCO Total Return B PTTBX
Management Fee 0.25%
Total Expense Ratio:1.65%
Max 12b1 Fee:1.00%
Max Front End Sales Load:0.00%
Max Deferred Sales Load:3.50%

YTD Performance as of 04/17/2009 1.87%
1 Year* 1.73%
3 Year* 5.37%
5 Year* 3.65%
10 Year* 5.15%

PIMCO Total Return C PTTCX
Management Fee 0.25%
Total Expense Ratio:1.65%
Max 12b1 Fee:1.00%
Max Front End Sales Load:0.00%
Max Deferred Sales Load:1.00%

YTD Performance as of 04/17/2009 1.87%
1 Year* 1.73%
3 Year* 5.37%
5 Year* 3.65%
10 Year* 5.15%

As you can see, your fees will vary depending on what type of shares you buy and how long you own the fund (due to exit penalties for B shares). I won’t go into the fact that the entire mutual fund industry fee structure needs to be sliced down. The growing ETF industry is helping to take care of that. The point here is that from a comparison basis, the fees charged by bond mutual funds are excessive even when compared to industry standards.

At least with equity mutual funds you have the potential to earn double-digit returns. With bond funds, it’s a much different story; that is, unless you’re talking about funds that manage primarily junk bonds.

If we did consider junk bond funds, you should note that the expertise and effort required would be considered much more than for investment grade bond funds. But the risk would also be much higher, while the liquidity would be significantly lower.

In contrast, for investment grade bond funds, your returns are pretty much constricted to a small range, namely around 5 to 7%, depending on interest rates and how well the bonds are managed.

Ask yourself the following question. With disclosed fees (not total fees) of over 1.5% and net annual returns of around 5-6% (depending on the time span under consideration), doesn’t this seem like a big rip-off? To me it does, especially when you can buy the bonds yourself for as low as a $50 (maybe lower charge) and get 6-8% for investment grade issues.

If you think the SEC would do anything about this ripoff, think again. I have already made a formal complaint. Their response? “Fees and returns are listed in the prospectus.” In other words, disclosure is suitable for screwing you despite the fact that this so-called disclosure is not clear. The fact is that it is very difficult if not impossible for the average investor to truly comprehend the fund stat sheet much less decipher the prospectus.

Of course part of the problem is that the mutual fund industry is allowed to report very confusing and select data which most investors do not fully understand. Ask yourself why these fees aren’t clearly communicated to investors? Then ask yourself just who you think the SEC works for.

Let’s have a look at some additional data. For the A shares (PTTAX), an initial $10,000 investment would rack up $1509, or over 15% in fees (not counting ticket charges) over a 10-year period (Yahoo! Finance). That is the amount that’s sliced from your gross returns; your “total return” if you will, before capital gains taxes of course. So already, you are paying over 1.6% each year for Mr. Gross to manage investment grade bonds that typically return net you around 5-6% individually.

As data shows, the fund has returned 4.90% annually over the past five years and 5.94% over the past 10 years. But wait a second. What about the fees? Well, a couple of years ago, the SEC finally started requiring returns to be reported after adjusting for fees. But they did not require funds to also report the gross returns before fees. So you need to do some simple math to determine how much you are really being charged.

So, take the annual returns reported and divide that number by the total fees; in the case of the A shares, 1.4%. Looking at the 10-year returns, simple math gives us around 24%. That is, PIMCO is getting 24% of the annual returns in fees. The fees are even higher if you use the 5-year returns.

But you still haven’t accounted for taxes. Note that while Fannie and Freddie are tax-exempt, when these bonds are sold (as often happens during the management process) you are responsible for capital gains taxes. But we still aren’t done. Once again, there are several fees that are not disclosed so you should assume these calculations to be higher. I would estimate the total fees to be 30-35% of gross returns. Wow. That sounds like a damn good business to be in (if you have no scruples).

The chart below should give you a pretty good idea about this fund. Note that the price chart is of the NAV and does not adjust for fees, so it looks a lot better than reality.

For the B shares, we don’t see much difference. A little shifting here and there with fees and we basically get the same situation. Management and 12b-1 fees are 1.65% in total. The deferred sales charge is 3.50% if you exit prior to (typically) five years.

You see, that’s why the annual fees are higher than with A shares. If you exit before five years, you get dinged with an additional 3.50%. See, they plan to get big fees from you either way. If you stay in the fund for at least 5 years (or the specific requirement which in some cases is 6 years), they’re nail you with a higher expense ratio than with A shares because the A shares nail you with an upfront sales charge.

I hope you see how mutual funds work. They play the same shell games as the credit card industry. No matter which share class you buy, you are going to pay huge fees. And investors who haven’t read this piece will never realize that.

So what’s the solution of you want a managed bond fund account? Well, you could go to managed money. The fees are smaller and the tax-loss selling is customized to suit you. An even better alternative would be investment in closed-end funds. The fees are taken from the NAV instead of your account and these fees are smaller than other managed funds.

Others who might not want any fees or risk to buy Certificates of Deposit.

Now if you happen to be thinking about investing in a bond fund for your 401(k), consider otherwise. You just might be better off with a large cap value fund that pays good dividends and has more upside potential than these bond funds that take away so much of your returns in fees.

Employees need to start requesting more investment options from their employers because having a 401(k) consisting of only mutual funds serves only the interests of the mutual fund industry. The fees are outrageous.

Let me make one thing clear. It doesn’t take a genius to uncover this disturbing reality about bond mutual funds. You just have to pay attention. And chances are, you can’t count on your adviser if you have one. There are always exceptions. Just don’t think you’ve run across one (as so many think they have) unless you REALLY have.

I also want to make it clear that this problem is not unique to Mr. Gross’ funds. It is a problem with all bond funds. I just wanted to highlight the problem using Total Return because it is the largest mutual fund AND because the fund grows almost exclusively by assets under management (investors buying the fund) AS OPPOSED to capital appreciation (which occurs with equity mutual funds). What this shows you is just how ignorant investors are.

In my opinion, these fees, given the nature of the investment type, should be ILLEGAL based on what I know about normal standards from the SEC and FINRA. But the mutual fund industry still has no real regulation. It has only recently fallen under token regulation by the SEC. Prior to this token arrangement, funds had absolutely no regulation whatsoever. Still, once again, all fees are not accounted for nor disclosed when reporting performance.

All it takes is some common sense and honesty. That is precisely why you will never hear anyone on Wall Street or on CNBC mention it. After all, they aren’t at all on your side. Once I found out how the game is played I left Wall Street in disgust.

Now, be a good citizen and forward this article to everyone you know so they will understand the truth.

NOTE: I continue to face widespread censorship for speaking the cold hard truth as I see it. My intention is to wake the people up so they will realize just how useless and deceitful the mainstream media is. I ask that you do your part to help with this mission by emailing my articles to your friends and adding the articles to the various online syndication options provided at the top right-hand side of each article. Together, we can make a difference.

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