The investment strategy Bill Gross took to become the Bond King : Planet Money : The Indicator from Planet Money Bill Gross is a retired investor known for creating and dominating the bond market. But what exactly made him so successful? Today, we talk to Aaron Brown, who created a mock portfolio to unpack the success of the Bond King.

Beating the bond market: Luck or skill?

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If you have checked your retirement account online lately - well, my advice would be probably not to. Agreeing with me here is our Planet Money colleague, Mary Childs.

MARY CHILDS, BYLINE: Hi. Thanks for having me. Excited to be here.

WOODS: We are very excited to have you, too. But yeah, this year has been really gnarly for financial markets. It's been bad for stocks. It's been bad for cryptocurrencies and even for the bond market - this multi-trillion-dollar market for the debt of governments and corporations and other borrowers. It's this corner of the financial universe that is meant to be a little more stable than the wilder world of stocks and speculative assets.

CHILDS: And the bond market vomiting is a big change. We've had decades of it basically just going up. And when markets are going up, pretty much everyone does well. A golden retriever with a bond fund would have probably done OK.

WOODS: I would have invested.

CHILDS: I would have, too. That's a very cute-sounding fund. In a huge bull market, skill kind of doesn't matter that much. When the market turns, though, that's when you really find out, as Warren Buffett says, who has been swimming naked.

WOODS: The golden retriever has been swimming naked.

CHILDS: Definitely the golden retriever.

WOODS: And this gives us a question - like, a serious question. It's particularly pertinent in the current moment. Like, can we figure out who's wearing a wetsuit? Like, who can actually ride that wave of the bond market with decorum and skill?


CHILDS: And I'm Mary Childs. Today on the show, we'll try to figure out if there is such a thing as a good strategy. And what better way to explore that than through the lens of probably the most legendary bond investor, Bill Gross, also known as the bond king? He, like, invented active bond trading.

WOODS: We'll follow along with a researcher who explored Bill Gross' strategies, and we're going to investigate whether Bill Gross was actually skillful or just lucky.


CHILDS: Bill Gross' tenure as the bond king at his company began in 1987 and basically stretched all the way until 2014. Over that time, he achieved a great investing track record. He was super influential. Client money poured into his fund. He was on CNBC and Bloomberg all the time. Everybody listened to him.

WOODS: But then starting in 2014, he had this five-year stint where he didn't do so well in the market.

CHILDS: And it kind of tarnished the legacy of his performance, and it made a lot of people ask that question - had he just been lucky all those years?

WOODS: Aaron Brown set out to answer this question. Aaron, among other things, researches quantitative investing strategies.

CHILDS: How did you get into finance in the first place?

AARON BROWN: I got in via gambling, and finance seemed very natural. And I discovered you could make a lot more money in finance. The other big advantage is you can tell your mother-in-law what you do, you know?

CHILDS: It's much more polished-sounding, even though it's fundamentally similar, in your view.

BROWN: It's fundamentally the same thing, yes.

CHILDS: (Laughter).

WOODS: Aaron saw the study a few years ago. I mean, a lot of people saw the study. It went kind of finance viral. And it looked at what Warren Buffett did over his decades investing in the stock market.

CHILDS: It found that Warren Buffett's returns appeared to be mostly attributable to using leverage, like being able to borrow money and then buying cheap, safe, quality stocks.

WOODS: So Aaron was inspired by this study to do the same thing but in the bond market.

BROWN: Most of my good ideas are simple thefts of an idea and say, well, why not do it for the best bond investor, too? Like, let's see if Bill Gross has alpha.

CHILDS: Alpha - the returns an investor can get that are not just whatever the market is doing. Like, if you did really great but you only did really great because the market went up, you didn't generate alpha. If you did better than the market - alpha.

WOODS: So Aaron has the general market performance, and it's just an index. This is the basket of securities that's meant to represent the whole broad market. It's a measuring stick - how everyone in the industry grades themselves.

CHILDS: And next, Aaron would have to break down what Bill Gross actually did.

BROWN: OK. So first, I get this idea. So then I talk to my friend Richard Dewey, who worked at Pimco and so had a lot of insight. And we had to gather data on Bill Gross' performance. We tried to gather data on his actual holdings. I really would have loved to do it that way, but they're just not available in enough detail.

CHILDS: Annoying, but fine - they can work around it. There was one big advantage here. Over the years, Bill Gross was constantly in the media talking about what he was doing, telling everyone about his strategies.

BROWN: And so we said, OK, replicate what he said he did. You know, listen to his lectures, talks, some papers, and let's do a simple-minded version of what he said he did.

WOODS: So Bill Gross would buy bonds that were graded as riskier than the other kinds of bonds. The companies had borrowed more money or they were lower-profit businesses or whatever. For whatever reason, they were graded risky, and other people were seeing this and thinking, ah.

CHILDS: (Laughter).

WOODS: I don't want to touch it. But, you know - but maybe they were a little bit too scared. So buying those somewhat scarier bonds gave Bill Gross a little extra return compared with his peers and the benchmark index, which was not buying those risky bonds.

CHILDS: There were two other main strategies they found - investing in mortgage bonds which other people thought were riskier than Bill did and, therefore, they carried a higher risk premium - extra compensation that Bill was happy to accept - and a strategy known as rolling down the curve.

WOODS: Rolling down the curve basically means selling bonds before they mature because, like with anything, the future is more risky the further out in time you go. So a bond that matures in 10 years is more risky than one that matures next year, and the prices reflect that. So Bill would sell his bonds as they got closer to maturing because, for him, they were no longer risky enough.

BROWN: So he said he did those three things. So we said, fine, we're going to construct three portfolios that just do those things, and we're going to measure Bill Gross' exposure to those factors.

CHILDS: So they build a fake portfolio of these three simple things. They mush them together. They add in a little extra to account for the direction of interest rates. And they track that fake portfolio through time to see how it performed.

BROWN: So we kind of get a synthetic Bill Gross you might call a mechanical Bill Gross.

WOODS: And he holds that up next to the real Bill Gross' returns in the markets, and they very nearly match.

BROWN: The synthetic Bill Gross has a very high correlation. It explains 89% of the variation of Bill Gross' returns. So every month, it comes very close to Bill Gross' return. You know, if you did a graph, they looked very similar. Then we found out, yes, Bill Gross did, in fact, do what he said he did.

CHILDS: Which is great - Aaron can say now he basically understands what Bill Gross did. How he achieved his outperformance was by doing the things Bill Gross said he was doing out loud at the time. Basically, he bet everyone else was being too conservative about slightly riskier companies, about mortgage bonds and about that declining risk as bonds get closer to maturity.

WOODS: But that only explained 89% of the extra returns that Bill Gross was getting above the benchmark. There was still that little extra bit of the extra.

BROWN: Bill Gross had 0.84% extra alpha - just magic, something he did that wasn't described by the things he said he did or some extra ability.

CHILDS: And this actually hits on this weird thing where those three factors, a lot of people like Aaron, people in finance and who study finance, don't actually count those as alpha. Like, yes, it's delivering performance over the market, which is alpha. But because you can mostly replicate those factors synthetically, that mechanical Bill Gross portfolio, it's not real alpha. To those purists, alpha is that extra magic that Aaron can't really easily explain.

WOODS: This is what finance people debate when they go for beers.

CHILDS: (Laughter).

WOODS: And Aaron has theories about what that extra was. But however Bill Gross got there, Aaron has proved that Bill Gross did have these insights. He had a strategy.

BROWN: What sets apart the Warren Buffetts and Bill Grosses is not any one year's performance. It's being able to do it for decades and keep it up even during the periods things aren't working, right? I mean, that's a real skill, and that's what sets them apart.

CHILDS: Aaron says to identify who is good in advance, you just listen to them as they're talking and decide if they sound like they have a real insight or if they are swimming naked.

WOODS: This show was produced by Jess Kung and was engineered by Josh Newell. It was fact-checked by Corey Bridges. Viet Le is our senior producer, and Kate Concannon edits the show. THE INDICATOR is a production of NPR.


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