Gundlach On How TOTL Outperforms

September 10, 2015

Jeffrey Gundlach requires no introduction. The DoubleLine chief executive and chief investment officer has built a reputation as one of the most insightful fixed-income investors. This year, he brought that expertise into the ETF space for the first time with the launch of the SPDR DoubleLine Total Return Tactical ETF (TOTL). The actively managed fund hit its first $1 billion in assets in just about five months, all the while outperforming its competitors. Gundlach, who is a keynote speaker at this year’s ETF.com Fixed Income Conference, taking place Nov. 4-5 in Newport Beach, California, shared with us what it’s been like managing an ETF portfolio, as well as his views on the world and on where the opportunities are.

This is the first of two parts; read Part 2 here.

ETF.com: What’s the most challenging aspect of managing an active ETF? Are there challenges you’ve found that are unique to the ETF structure?

Gundlach: It’s exactly the same from our perspective as managing a mutual fund. There's really no difference at all because we’re not really administering it, State Street Global Advisors is doing that. I'm sure there's a lot of work at their end that would be challenging if we tried to do it ourselves. But we’re not doing that.

ETF.com: As a fixed-income investor, what metrics do you look at when you're deciding on allocation changes? Have you made allocation changes to TOTL since its launch that you didn’t quite anticipate?

Gundlach: There's certainly no deviation from what our normal procedure is, so therefore no deviation from what we would’ve anticipated. We make allocation changes in fixed income based upon, first and foremost, big relative value—valuation of sectors.

We subdivide the fixed-income market into Treasury bonds, mortgage-backed securities, investment-grade corporate bonds, below-investment-grade corporate bonds, bank loans, commercial mortgage-backed securities, developed-market bonds and emerging market bonds. These are the building blocks.

We have broadly characterized bonds into two fundamental categories: those that have a backing of a government guarantee and those that don’t. Our first allocation decision is what fraction of the portfolio we want in government-guaranteed bonds, and what part of the portfolio that’s subject to corporate default risk or securitized default risk. That judgment has a lot to do with our viewpoint on inflation in the global economy. The weaker the global economy and the lower the inflation rate, the more you want government bonds. The higher the economic growth, the safer corporate bonds are.

That decision has a lot to do with valuation as well. There are times when the global economy is very weak, like 2009, but government bonds are really expensive, reflecting a lot of already-occurred flight to quality.

Gundlach: When it comes to the credit risk, we make judgments on what are the most potentially rewarding and lower-risk ways of obtaining the potential rewards by emphasizing one sector over another. For example, entering 2014, we had virtually no high-yield bonds at all, but we had emerging market bonds. We took credit risk, but it wasn’t in U.S. high-yield corporate bonds.

In TOTL and in other portfolios, we have marginally decreased our corporate credit risk over the past few months. We don’t have any expectations in how we’re going to allocate, so it’s not like we’ve deviated from expectations, it’s that we react to changes in the market, changes in valuation and changes in the economy.

ETF.com: The performance of TOTL so far this year has been practically flat. Are you happy with that performance? Is the fund at this moment more about capital preservation?

Gundlach: No, we’re trying to outperform competing bond products. We would compare it to other bond mutual funds and other bond active ETFs. There's really only one other big active ETF that PIMCO runs [the PIMCO Total Return Active (BOND | C)]. And we've outperformed it by a pretty decent amount. We've also outperformed index funds by a fair amount. We manage TOTL relative to a benchmark index. It’s not an absolute-return product, so we’re looking to offer higher returns than other bond-market-focused alternatives.

ETF.com: Any assets you're absolutely shunning right now?

Gundlach: We’re shunning emerging market equities pretty heavily here. The China aspect of emerging markets is very troubling. And emerging market equities are performing so badly that it just seems like one of these falling knife situations. If you look at the iShares MSCI Emerging Markets ETF (EEM | B-100), it’s at a lower level now than it’s been at any time in 2010 through 2014. That might mean it’s a buying opportunity. But when you look at the chart, it looks really bad. So we’re not really interested in broad emerging market equity exposure.

ETF.com: Do you think high-yield credit spreads are going to continue to widen? And is that largely related to oil?

Gundlach: I don’t have an opinion on that. We thought they would widen, so we allocated down from high-yield bonds in June. We bought investment-grade corporate bonds.

We had been at a maximum underweight in investment-grade corporate bonds starting this year. It was our biggest allocation statement. We thought that investment-grade corporate bonds were the most overvalued in the history of our analysis, which goes back about 30 years. And for that reason, we entered 2015 with our lowest-ever allocation to investment-grade corporate bonds. We’ve never been lower in my 30-plus-year career.

In June, investment-grade corporate bonds had mightily underperformed high-yield bonds. High-yield bonds were up 3 or 4 percent. Investment-grade corporate bonds were down a percent or two. So that metric that was in place of overvaluation entering the year had changed.

So we sold some high-yield bonds, and we bought investment-grade corporate bonds back in June. Now, high-yield bonds look to us to be fairly valued versus Treasury bonds—not all that exciting, not all that bad. But it’s really going to be dependent upon commodity prices for sure.

Gundlach: When commodity prices are falling, it’s indicative of a lack of pricing power for commodity producers and commodity corporations. And it’s also indicative of weak global growth. Those things are bad for credit investors. It increases the chance of default.

Recently, you saw the commodities find a floor. But it remains to be seen whether that’s a floor or whether we’re going to decline again. It seems to me that commodity prices have probably bottomed, over the short term. And so, probably incrementally, the pressure on high-yield bonds in the short term is somewhat lessened.

ETF.com: Has the tide finally turned in oil markets?

Gundlach: I've been of the opinion that oil would not rally very much, but it also wasn’t going to go to $20 like you’ve heard a lot of the real mega-bears talk about. And certainly, it seems like it has a hard time staying below $40; even seems to have a hard time staying much below $45.

Is it going to start rallying? In a certain sense, I think yes, because I don’t think it’s going to fall. But that’s not really what’s important for the oil market. What’s important for the oil market is, will it stay below $60? If oil rallies up to $49, it doesn’t do a lot of good for the oil service companies and the oil producers. It needs to go higher than that.

I don’t know if the tide has turned. If you define it as oil is going to stop dropping, that’s probably good. If you mean oil is going to rally up to a point where there's no stress in the commodity economy, I don’t agree with that.

ETF.com: Why is what happens to commodity prices—particularly oil—crucial to fixed income?

Gundlach: That’s been the case for decades. Oil is an incredibly important commodity. And oil correlates pretty highly to directions in interest rates. That’s because oil is a centerpiece-type commodity for inflation. Bonds care a lot about inflation. For government bonds, inflation is the most important thing. And oil is a harbinger of inflation. It’s not surprising that collapsing oil prices lead to a downgrade of inflation expectations, which leads to, on the margin, further support for bonds.

What's been curious in the last month is that oil prices have been on a wild ride, and commodity prices generally have been on a wild ride. And yet for the month of August, the bond market was down in terms of total return, which is strange given the tremendous collapse that occurred in the commodity complex. If you're going to take 20 percent out of the oil market price, under conventional wisdom, you’d’ve expected interest rates to fall substantially, not just 15 basis points or so, as we saw.

But again, go back to the Rosetta Stone. Why did this happen? Because oil collapsing meant the Fed was less likely to tighten. The more you analyze the markets, the more you realize the message has been crystal clear now, for nearly two years. The long bond wants the Fed to tighten. And I know that a lot of people have a hard time with that notion, but it’s difficult to look at the market data objectively and come to a different conclusion.

People are far too committed to the idea that interest rates are about to explode higher. That’s been the wrong idea for years. And we’ve jumped to the wrong conclusion that the Fed tightening is somehow a disaster for long-term bonds. It’s exactly the opposite.

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