The managers for the world's largest bond fund have some explaining to do.

The newly minted PIMCO Total Return ETF (exchange traded fund) outperformed the PIMCO Total Return mutual fund over the last four months by more than 3 percent. The outperformance by the ETF has created a stir because both investment vehicles have the same manager and an identical investment strategy.

The flagship fund for the Pacific Investment Management Co., better known as PIMCO, is the 25-year-old Total Return Fund, which is a bond mutual fund with $263 billion under management as of July 9, 2012. In late February, PIMCO created an exchange-traded fund, the PIMCO Total Return ETF, which has the same strategy and manager as its older and much larger sibling, but that's where the similarities end.

The performance of the two funds highlights the structural differences in ETFs and mutual funds and also how fund size and age can play a role in performance. As of July 9, 2012, the Total Return ETF has only $1.8 billion under management, a fraction of its mutual fund equivalent.

In an article by Bloomberg Businessweek, fixed income manager with DoubleLine Capital, Bonnie Baha, when referring to PIMCO's performance was quoted as saying that "it is very difficult to beat the market when you are the market." She goes on to say, "Once you get to a certain size, your ability to add value is constrained almost by definition."

Baha added, "If you believe in the efficient-market theory, the bigger you get the more difficult it is to add value because your choices are more limited."

While Baha's statement may be conventional wisdom for equity mutual funds, bond funds generally aren't thought to have the same issues. The size of the credit market is much larger than the equity markets. According to the Securities Industry and Financial Association, the size of the U.S. bond market is just under $37 trillion to date, making the Total Return Mutual fund's holdings a fraction of the market.

So why were the returns so different?

For starters, the ETF holds about 300 securities and the mutual fund holds more than 19,000. The mutual fund uses derivatives to simulate an investment holding or to hedge its losses, while ETFs are not allowed to use certain derivatives.

According to a recent Financial Times article, PIMCO's Total Return mutual fund holds credit default swaps which serve as an insurance policy against certain bonds if they default. The cost of the credit default swap acts as a drag against performance relative to the ETF, which can't hold such instruments. If the credit market begins to undergo defaults, it is possible the unhedged Total Return ETF would see greater losses than its mutual fund equivalent.

The rest is here:
Personal Finance: PIMCO returns differ from similar accounts