The
departure of Bill Gross from Pimco may provide the most interesting industry gossip we've seen since the
acrimonious departure of Jeffrey Gundlach from TCW. The headlines surrounding Mr. Gross are less lurid than those surrounding Mr. Gundlach, though we are amused by reports that Mr. Gross
compared himself to Kobe Bryant and Mr. Gundlach to LeBron James in their discussions about creating a “Dream Team” of bond legends. We'll save debate over whether we should
anoint Dan Fuss as the Michael Jordan or Magic Johnson of the bond market for a later date. All jokes aside, we think this is a momentous transition given the prominence of Mr. Gross and Pimco in the fixed income markets as well as the continuing debate about whether mutual funds should be considered systemically important financial institutions.
Should I stay or should I go?
We've seen much debate about whether investors should abandon the Pimco Total Return Fund and Total Return ETF. Our point of view leads us to some different conclusions and resultant recommendations than what we're seeing in the industry press. Both of us have considerable prior experience with the Pimco Total Return Fund. Gerard was familiar with the fund from his background creating recommended lists of mutual funds for a major broker-dealer; Dan equally familiar as an investor in the fund on behalf of several of the mutual funds he managed for the asset management arm of the same organization. We had spirited discussions about the Pimco Total Return Fund when we joined Advisor Partners in 2011, ultimately deciding not to invest in the fund for a variety of reasons including fund size, resultant loss of investment flexibility, and our perception that the fund was tending to make more top-down thematic bets often with the use of derivatives. Because we don't have money in the fund or a vested interest in any of the warring parties, we're well equipped to be informed and reasonably unbiased observers.
(More reading: Where all those Pimco outflows actually going?)
The bull case for the Pimco Total Return Fund and ETF
Proponents of the Pimco Total Return Fund and Total Return ETF point out
the deep bench behind Mr. Gross at Pimco, including well respected bond managers such as Pimco's new chief information officer Dan Ivascyn. They also point to the internal relief as the firm heals from the conflict that permeated around the firm in recent months. We completely agree with the assessment of the overall talent that remains at Pimco. Dan remembers leaving a day-long due diligence visit to Pimco a few years ago thoroughly impressed with the depth and breadth of talent within the firm's investment staff, realizing that Pimco was far from a one man show. He remembers commenting to his team about his admiration of Pimco's investment team while commenting only somewhat jokingly that even Pimco's product managers were stronger investors than many of the investment people that we visited on a regular basis.
(More on Dan Ivascyn: A low-profile insider forced to fill the shoes of an investing legend at a difficult time)
The bear case for the Pimco Total Return Fund and ETF
The bear case is simple and familiar. Money will depart the fund and ETF, a trend that started before Mr. Gross departed. $23 billion of outflows from the Total Return Fund in September is significant, even for a $200 billion fund. Cynics commenting on Mr. Gross's outspoken communication style say that it's okay to be “difficult” as long as performance is good, but not so okay when performance is bad. The rumor mill is rife with speculation about whether Pimco will be able to raise the money necessary to meet redemptions, speculation that Pimco supporters rapidly counter by pointing to the highly liquid Treasury holdings within both fund and ETF.
(Related: Fidelity targets wounded Pimco, launches bond ETFs)
Our point of view
We have few doubts about the longterm viability of Pimco, but think that many commentators are missing key points about the near-term prospects for the Total Return Fund and ETF. First, the numbers don't lie. Money
is flooding out of the fund and ETF, and those outflows don't come without cost to the remaining shareholders. There is a cost to trading, even in highly liquid Treasury markets, and the sheer magnitude of trading will depress returns. Perhaps more significantly, market impact costs will also hinder returns until the asset base stabilizes. The
news about Mr. Gross caused or coincided with rising yields for Treasurys and TIPs, and widening spreads between high yield and Treasurys.
The second more subtle implication of the outflows from the fund and ETF lies in the potential changes in risk profile that occur as a byproduct of the liquidation process. Most commentators point to the liquid holdings, such as Treasurys, gaining comfort that liquidating shareholders will be able to collect their proceeds. That assessment is accurate as far as it goes, but ignores some key issues.
We recall large outflows from funds during the financial crisis. In many cases, funds with large outflows sold their most liquid securities to meet redemptions, ultimately leaving less liquid and higher-risk securities in the portfolio. Dan remembers asking a renowned deep value investor why he was concentrated in a handful of stocks in his flagship fund. The response was that the investor had sold most of the liquid securities in the portfolio, ending up with a highly concentrated portfolio not by design, but as an unintended consequence of several months of heavy redemptions.
We think it reasonable to consider that the flood of money out of the Pimco Total Return Fund and ETF will create an unbalanced portfolio with a different risk profile than originally expected by shareholders. Uncertainty created by Mr. Gross' departure will create transition difficulties relating to people and process. It's likely to take some time for the new leadership team to place their “stamp” on the fund, a process complicated by the need to reassure institutional investors and consultants that the firm will survive the high-profile departure. Time spent on television and in client meetings is time away from the bond market, and will likely have an adverse impact on near-term performance.
Daniel Kern is president and chief investment officer and Gerard Cronin is portfolio manager at Advisor Partners. Email Daniel here, and Gerard here.
