Chuck JaffeBill Gross isn't worth this fund's high price
7/18/12 1:53 PM ET (MarketWatch)
BOSTON (MarketWatch) -- Bruce is a 73-year-old semi-retiree in Champaign, Ill., who is frustrated in his search for income in the current market.
"Honestly, I don't think God himself could make a solid 6% or 7% that I would feel comfortable with," Bruce said by email.
That being the case, Bruce is thinking of turning to a higher power to generate income: superstar money manager Bill Gross.
Specifically, he's looking at Gross'
It's a move that a lot of yield-starved investors have made -- and been rewarded for -- but, unfortunately for Bruce and others, buying Pimco High Income (PHK) now would be the Stupid Investment of the Week.
Stupid Investment of the Week showcases conditions and characteristics that make a security less than ideal for average investors, in the hope that spotlighting danger in one case will make it easier to root out and avoid trouble elsewhere.
While obviously not a purchase recommendation, the column is not intended to be an automatic sell signal. Pimco High Yield investors could face significant tax consequences from unloading a fund that is at the top of its peer group over the last three years and near the lead over five years, according to investment researcher Morningstar Inc.
Price of excess
That success is precisely what would attract an investor like Bruce , especially knowing that Gross took over the fund in 2009, a year in which it gained 135%, and has been at the helm -- supported by almost 50 analysts -- ever since. So far this year, Pimco High Income is up 23%.
The problem is that shareholders are overpaying for Gross's expertise.
Closed-end funds are specialized portfolios of securities that trade like a stock. Unlike traditional mutual funds, which always trade at the net asset value of underlying holdings, a closed-end fund's price is determined by market forces, and trade at a discount or premium, based on market sentiment.
People are so anxious to sign up with Gross right now that Pimco High Income is trading at a premium to net asset value of more than 75%.
Bruce says he doesn't mind that because it's "for Bill Gross and an 18% distribution," but the problem for most investors (Bruce included) is that they don't understand quite how the distribution works.
For starters, scrape off that premium, and the real distribution is in the neighborhood of 10.5%. That's nothing to sneeze at -- it's still above the average for high-yield closed-end funds -- but then dig a little deeper and it's clear that the distribution attributable to income and capital gains is actually closer to 7%.
The difference between those two numbers -- assuming Pimco holds its distribution steady -- will be paid in a return of capital, which isn't "income" so much as "getting your money back disguised as income."
Then, look at how the premium distorts the perception of performance for the fund. In 2011, Pimco High Income was up 6.4% based on its share price. The net asset value of the underlying holdings, however was a loss of 5.2%. That was dead last in its Morningstar peer group for the year.
In short, if PHK had been a traditional fund, it would have been a loser, and it was only the irrational exuberance of Gross supporters that propped up the price.
Even at a time when most income-oriented closed-end funds are trading at a premium -- which is unusual -- the huge premium on Pimco High Yield is extreme.
Gross manages other funds with big premiums -- and it is worth noting that PHK traded close to its net asset value before Gross took over -- but investors don't need to pay so much extra to get a star, even if it is Gross.
Cheaper alternatives
Gross is a busy guy, and investors can get his management in other ways, even in the closed-end space.
Pimco Income Strategy II (PFN) is also run by Gross, has a strategy that is virtually identical to the High Income -- it may be less risky due to fewer corporate bonds and more municipals -- and it trades at a current premium of about 6%. The distribution rate is roughly 9%, but that payout number is more real than what investors are getting out of Pimco High Income.
"I would sell [Pimco High Income] with both hands," said Maury Fertig, chief investment officer at Relative Value Partners in Northbrook, Ill. "There is infatuation with the yield on this fund and [the yield] is definitely not sustainable over time. One day they will need to cut this dividend, and look out if you own it [when that happens]."
One other cautionary consideration for PHK comes in the form of the common-sense investment idea that too much yield is a danger sign.
Here's where Bruce acknowledged something that most PHK investors may not want to admit: If it was anyone but Gross running the fund, he wouldn't consider pursuing an 18% distribution rate. "It's too high, I'd be scared," he said, "but this is Bill Gross."
Steven Pikelny, who follows Pimco High Income for Morningstar, said he believes that most investors see Gross's name as lead manager, see the big distribution rate and buy without doing their homework and without giving the premium a second thought.
"As good of a manager as Bill Gross is, he's not a magician," Pikelny said. "You're taking on risk to yield the original distribution, so investors are taking 18.6% in risk, but they're only getting about 7% in return on it, and I suspect the distribution is not sustainable.
"There are plenty of muni-bond closed-end funds and other funds out there where you can get a 7% yield, but you're only taking on the kind of risk that you should take to get that kind of return," he added. "Paying too high a premium to buy [Pimco High Income] doesn't feel like a problem now; if you bought the fund because you trust Bill Gross, you will only realize the problem of paying too much when it's too late."
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