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It's Time for PIMCO and Its Fund Board to Step Up

PIMCO should bring policies in line with its world-class reputation.

Eric Jacobson, 02/08/2011

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PIMCO isn't just one of the biggest asset managers in the fund industry. It's also one of the very best.

It has a record of delivering excellent returns for most of its clients. It boasts a culture that, while obsessive, high-pressure, and ultracompetitive with its rivals, keenly understands risk from almost every angle. That starts at the level of individual holdings, but PIMCO managers pay an enormous amount of attention to portfolio-wide dangers, the macroeconomy, and even risks to the reputation of its entire franchise. All in all, it is a world-class organization.

But the P in PIMCO does not stand for "perfect." One flaw is the firm's structure of mutual fund pricing, disclosure, and governance. That stands in odd contrast to the otherwise investor-centric nature of its overall culture.

The good news is that there are signs PIMCO may finally be willing to address some of those shortcomings. The firm recently announced it will soon take over all sales and distribution tasks for its retail (noninstitutional) share classes, which had long been handled by another subsidiary of parent Allianz. The head of its new distribution operation has hinted in some interviews that fee cuts of some type are on the horizon.

That could benefit shareholders of PIMCO's funds. But in order for the stature of its mutual fund house to approach PIMCO's deserved reputation as an asset manager, the firm will have to address other issues.

Independence Day
One key issue is just who gets to sit on and ultimately control the board of directors of the PIMCO funds. Morningstar views board independence as a cornerstone of good mutual fund governance. Therefore, when calculating Stewardship Grades for funds, Morningstar awards credit only to fund boards with independent chairmen and a membership that is at least 75% independent. PIMCO's fund board does not meet either criteria, given that board chairman Brent Harris is a long-tenured PIMCO executive, and only five of the board's seven trustees are independent. (The firm's new equity funds are overseen by a board of three people, each of whom sits on the bond funds' board as well; Harris is the chairman of that board, which also falls short of Morningstar's 75% independence threshold.)

PIMCO questions the need for an independent chairman and a higher level of independent board membership. The firm has been adamant that its board serves investors well. Harris has argued that board members historically have been carefully recruited for their experience and business judgment and has noted that issues requiring a vote of the board--such as fees, board compensation, and oversight of the chief compliance officer--also require the presence of independent board counsel and a recusal of management. In fact, Harris has said that, if anything, more input from fund management is needed in full board meetings to provide balance for discussions that occur in insular, independent trustee meetings. He believes that efforts to reach higher ratios of board independence risk the inclusion of unqualified members.

Any Club That Will Accept Me as a Member . . .
There seems to be little risk of the board being infiltrated and overwhelmed by unqualified newcomers, though. One reason is the lock-tight control it exerts on its own membership. In fact, the rules governing how new members may be nominated to the board are more restrictive and potentially exclusive than any others Morningstar has ever observed among open-end mutual funds.

The criteria are laid out in PIMCO funds' Statement of Additional Information and, in simplified form, look like this: You have to own at least 5% of a fund and have done so for at least two years, just to nominate someone for the board. The nominee can't be you, anyone you're closely related to, or anyone who works for you. In other words, it's extremely difficult for a shareholder of any size to get on the PIMCO funds' board or, for that matter, to freely choose another nominee for the position. Even if you somehow had more than $12 billion--5% of its current net assets--in PIMCO Total Return PTTRX, for example, you still couldn't nominate yourself for a seat on the board.

Morningstar has raised this issue with PIMCO and the board, and it turns out the rules were adopted from a 2003 SEC proposal (revised at least once thereafter, but never implemented) that was apparently designed to try to ease proxy access to corporate boards for shareholders of regular operating companies. Although that proposal seems woefully inadequate and ill-suited to open-end mutual funds, it appears PIMCO looked favorably on the restrictive rules as a means of protection from takeover tactics common to the closed-end fund universe.

Whatever the origin or intent, however, the rules effectively prevent shareholders from choosing who will represent their interests on the board. It's frankly shocking that an asset manager as good as PIMCO runs funds with a governance structure this bad.

Prix Fixe
A more arcane issue that falls under the board's domain is the way in which PIMCO accounts for and reports the expenses of its funds. The firm breaks down the bulk of its funds' costs into the two large line items of "investment advisory fees" and "supervisory and administrative fees." What's noteworthy is the parity between those line items.

The firm's flagship Total Return fund is a good illustration. For the fiscal year ended March 2010, Total Return's advisory fees added up to more than $458 million, while its supervisory and administrative fees clocked in at $454 million. The proximity of those numbers is perplexing because the first number should be what shareholders are paying for the expert, value-added services of an active money manager, while the second should account for the commoditized costs that are otherwise associated with operating a fund and servicing shareholder accounts. Even if one were to argue that some providers of "supervisory and administrative" services warrant more compensation than others, it doesn't make sense that the true cost of servicing PIMCO's funds is anywhere close to the fair value of investment advisory services--for one of the best mutual fund managers around.

Indeed, among the most critical functions of fund boards is to negotiate fee agreements with fund advisors and service providers. But fees for PIMCO share classes sold through advisors or directly to investors (as opposed to institutional classes) are generally not competitively priced. More than 40% of the PIMCO funds that Morningstar covers and which receive Stewardship Grades, for example, have expense ratios that are higher than the norm for similar peers'.

PIMCO and the board both encourage investors to look past these breakdowns and simply evaluate fund costs as they appear in total, and both have argued that the funds' high returns justify their premium prices. The firm's assets under management and the funds overseen by this board have grown tremendously over the years, though, and several are among the largest in their respective categories. Premium pricing notwithstanding, there are economies of scale that have simply not been passed down to shareholders.

The most damning indictments on fees, though, have come from PIMCO co-founder and co-CIO, Bill Gross, who effectively called bond-fund fees ranging from 75 to 100 basis points an "extreme absurdity".

It's Time
The ultimate problem, however, is that it doesn't matter how PIMCO would like to position its fund costs. It's up to the funds' board to oversee such issues in a way that best serves shareholders of the funds. The opacity of those data, combined with their girth, suggests that the board has not done enough to aggressively negotiate for better economies of scale or even help investors better understand why the fees they pay are appropriate in the board's opinion. That includes not only making sure that cost data are transparent, but that shareholders are getting the best deal possible for the services that are being provided.

In fact, regardless of how carefully the board has considered the pricing of PIMCO's investment advisory services, there's no indication it has spent much time looking at whether the costs for supervisory and administrative services are anywhere within range of market norms. That's an area that begs exploration given the commodity nature of--and highly competitive environment to provide--such services.

The unspoken truth is that, deep down, virtually no mutual fund company really wants an independent board mucking around with its funds or getting overly involved with how they're priced. The best firms understand, however, that there's a fallacy in the previous statement. The funds don't belong to the firms--they belong to shareholders. PIMCO knows that. The PIMCO fund board knows that. It's time for both of them to show it.

Eric Jacobson is an analyst with Morningstar.

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