Fund Manager Interview
Our investment manager interview for this issue is with John Brynjolfsson, Managing Director,
portfolio manager and head of the $4 billion PIMCO Commodity Real Return Strategy
Fund.
KRA: John, that’s an interesting and lengthy name. Can you give us an overview of the fund?
JB: Sure. The PIMCO Commodity Real Return Strategy Fund is an enhanced index fund focusing
on commodities. It combines a position in commodities, typically through swap agreements,
backed by a portfolio of inflation-indexed bonds and other securities. It takes an innovative
approach to commodity index investing by combining active and passive management, and seeks
to take advantage of PIMCO’s extensive experience managing both index-linked securities and
inflation-indexed bonds.
KRA: What index do you utilize?
JB: While there are many published indices that broadly encompass the commodities markets,
the one we utilize for our fund is the Dow Jones AIG Commodity Index. It attempts to capture
the economic importance of various commodities by measuring trade-weighted volumes. So while
oil is a big component, it does not dominate the index. Industrial metals, precious metals, corn,
soybeans, pork bellies, and other commodities also make up the index, as well as crude oil,
gasoline, etc. Our fund begins with exposure to this broad menu of commodities through total
return swaps.
KRA: Is it primarily for investors who feel optimistic about commodities?
JB: As an asset class, commodities can be a good portfolio diversifier because they have a
negative correlation to both equities and conventional bonds and a positive correlation to
inflation. Potential investors should share that opinion and also recognize that commodities are
relatively volatile.
KRA: Do you lever the commodities?
JB: We do not. If we are buying 1,000 barrels of oil using commodity futures or embedded within
the index, we will buy back roughly $30-36,000 worth securities, meaning that although we’re
using futures and swaps, it doesn’t represent a levered investment. All the same, oil and other
commodity prices do fluctuate, roughly about the same as equities. The annualized volatility of
the commodity index is in neighborhood of 14-20%, which is transmitted through to the fund’s
volatility.
With that as our primary investment exposure, we are left with the cash proceeds representing
the actual assets of the fund. We could have put those proceeds into T-Bills as a way to back the
commodity futures, but we chose TIPS (Treasury Inflation Protection Securities) because we
believe they are a better vehicle. The TIPS portion of the portfolio is run much like PIMCO’s Real
Return Bond Portfolio, that is, we buy a mixture of inflation-linked bond maturities in order to try
to outperform a passive benchmark Treasury Inflation Index Bond while opportunistically using
other types bonds in the portfolio as well.
KRA: What percentage of the portfolio is typically in TIPS?
Generally, about 80% of the portfolio is in TIPS but we have the flexibility to take that down if
we get unduly pessimistic about the return outlook for TIPS and we can use other instruments,
such as a small amount of emerging market bonds, high-yield corporate bonds, mortgages,
floating rate corporate bonds or foreign government bonds as well. This is what’s called a “full
discretion” fund, which means we try to implement as many of the PIMCO strategies as we can
into the structure while focusing on 100% exposure to commodities within operational
tolerances.
KRA: Can you explain how the fund is managed both actively and passively?
JB: Management is passive in that we do not actively select commodities. Our commodity
exposure is fixed at index proportions and at 100% of the account’s market value. That does
fluctuate from time to time due to subscription or redemption activity, and there may be some
capital gains (or losses) associated with the inflation-linked bonds that could make the
commodity exposure higher or lower than 100%. It’s rebalanced monthly for TIPS market
fluctuations. So our inflation-linked benchmark is passive and that’s what we are striving to
outperform with our TIPS portfolio.
Management is active in that we can manage the duration of the TIPS to be longer or shorter
than the benchmark. It is also active in that we can manage the curve structure of the TIPS. If
we concentrate exposure in the intermediates, it’s called a bullet portfolio; if we disbursed the
TIPS exposure into the short and long end wings, it’s called a barbell structure. Management is
also active in that we can use a variety of securities in the portfolio to implement other fixed
income strategies and even short or hedge interest rate exposure by either selling derivatives
or using interest rate swaps within the portfolio.
KRA: Were there other commodity indices you could have used as a benchmark?
There is a Goldman Sachs Commodity Index, which is more energy-focused than the Dow Jones
AIG. That can be good if energy is going up and during most normal periods because energy
tends to have a lot of “roll-up”, that is, be backward dated so investors benefit from the
dynamics of the futures market. The major advantage to using the DJ AIG index is it is more
broadly diversified and so less volatile. That’s a significant benefit for many investors.
KRA: How many assets do you manage in the fund?
Growth in the fund has been rapid. We currently manage over $4 billion in assets. We have been
very successful in terms of performance, particularly during the last six months as commodities
have come to the forefront of the investment arena.
KRA: What are the advantages of the fund versus other uncorrelated strategies?
JB: Inflation-protected securities and inflation-linked bonds are compelling because they are
contractually indexed to the CPI, which provides inflation protection. There is any number of
ways to get exposure to commodities. You can buy equities related to commodities, such as
shares of Homestake Mining, but there are several risks: too narrow a focus on just one
commodity; the potential for certain economic factors related to that particular company but not
to the market for that commodity may come into play; and the possibility that the company’s
management may be very shrewd or inept, affecting the performance of that equity while having
little or nothing to do with the underlying commodity. For example, a gold producer might hedge
its profits by selling gold in the forward market, which means if the price of gold goes up, rather
than profiting from it, the company will merely break even because it has already sold that gold
at a predetermined forward price.
Another possibility is to choose an actively managed commodity strategy, but that typically
translates into merely buying into the success or failure of a given commodity, trading advisor or
other individual or company engaged in the business. Depending on their particular business
model or investment philosophy, a trading advisor may decide S&P futures or bond futures are a
good instrument to hold. Those are both financial instruments which represent the opposite of
what investors typically look for when they get into real assets or commodities, and there can be
a lack of control, transparency or the potential for changing strategies.
The index approach we take is to broadly expose the fund to all major commodities in relatively
fixed proportions. We believe it’s the best means to get broad exposure to what’s happening in
the commodity markets. When you combine that commodity strategy with a TIPS strategy, you
get a one-two punch that will do very well in a reflationary environment or one where the Fed is
relatively easy and inflation is grinding or even accelerating upward. If inflation was to fall or we
were to go into a disinflationary or deflationary environment, I would not expect the fund to do
well. Volatility is 15-20% because you have both commodities and inflation-indexed bonds, and
the two could be additive. So we are not talking about volatility akin to a money market fund or
even a bond fund, but more akin to an equity fund. My hope is the fund will tend to be
negatively correlated with equities so that if equities go down, the fund would tend to go up.
KRA: Do you think less sophisticated investors or those unfamiliar with TIPS and futures markets
may shy away from a fund that can utilize derivatives?
JB: It’s important that investors recognize there are different types of derivatives. Some are
exotically-structured products designed principally to elude guidelines and restrictions, avoid
taxes, or for other, similar purposes. Those products are frequently priced with a lot of slush for
the structurer or issuer. That’s clearly not the type or derivative we’re talking about here.
The other type of derivative is highly liquid, transparent, widely traded, and more generic in
nature, such as interest rate swaps and the like. So we use this type of derivative to manage
interest rate and curve exposure in our portfolios. It’s a way to get commodity exposure from the
physical commodity market into the commodity futures market and ultimately, using a total
return swap, into our client portfolios. .
KRA: How do you find undervalued inflation-indexed securities?
JB: What I can tell you is our strategy involves bottom-up securities selection and also top-down
analysis, which helps us position the overall duration of the portfolio and curve structure to profit
in the economic environment we foresee going forward.
KRA: What type of investor do you look for?
For investors primarily looking to minimize risk in their portfolio, I would suggest they allocate a
significant portion into more conservative funds, such as a money market fund or even a real
return bond fund. A commodities fund is more appropriate as “spice” in the mix. Whether that
spice translates into a 2,3,4,5 or 10% allocation depends on the investor’s objectives and risk
tolerance. If someone is a very sophisticated investor who is aggressively focused on a
reflationary scenario, they may want as much as 20 or 30% in the position, but for the average
investor, somewhere between 1 and 10% would be a normal operating range I think. I
understand you typically recommend 5-7% for your clients, Karl, and that’s fine.
I could suggest a similar strategy using equities but equities have become so generic and
ubiquitous that holding them as the majority position in a portfolio, given their volatility, makes
little sense to me. I see more and more institutional investors and sophisticated high net-worth
individual investors moving away from traditional 60-70% equities-weighted portfolios and
towards a more diversified strategy of risk assets, including vehicles like emerging market bonds,
high-yield bonds and commodities, as well as products PIMCO doesn’t offer, such as timberland,
hedged funds, long-short strategies, and other strategies that seek to add alpha and value but
aren’t simply a one-horse bet on which direction the equities market is headed.
KRA: Finally, can you explain what you mean by double real market exposure?
Double real market exposure means if you put $100 million in the Commodity Real Return
Strategy Fund, you get $100 million in TIPS holdings and you also get $100 million of commodity
exposure through the total return swap. In effect, the TIPS are the security backing the
commodity swap. So you might think of TIPS as being a real asset and the commodities as being
a real asset.
Commodities are typically backed by T-Bills, but we are backing commodities with an inflationindexed asset, so now our investors get double real protection from both parts of the portfolio,
each representing 100% exposure. In effect, investors are almost getting 200% of inflationprotected exposure from their investment.
KRA: Thanks, John. I think we all have a clearer understanding of the fund’s strategy now.
John Brynjolfsson is also co-author of Inflation-Protection Bonds and co-editor of The Handbook
of Inflation-Indexed Bonds. He holds a bachelor’s degree in Physics and Mathematics from
Columbia College and an MBA in Finance and Economics from the MIT Sloan School of
Management. Mr Brynjolfsson has been with PIMCO since 1989.