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PIMCO's All Asset Funds Risk Becoming Too Popular

Larger asset bases could curtail flexibility.

Kevin McDevitt, CFA, 02/21/2013

PIMCO may be starting to wonder whether it planted two of its trees too close to the house. The funds in question, PIMCO All Asset PASDX and PIMCO All Asset All Authority PAUDX, have both grown to perhaps unimagined heights. From fairly modest beginnings about a decade ago, these two world-allocation funds of nearly equal size now claim about $64 billion in combined assets as of January 2013. Within the firm, that leaves them second in size to only flagship PIMCO Total Return PTTDX, the largest U.S. mutual fund, with a staggering $286 billion in assets.

Of course, this isn't a proper comparison because the two All Asset funds, both managed by industry veteran Rob Arnott, are funds of funds. More specifically, they're funds of PIMCO funds. So, any inflows that the All Asset funds receive ultimately pass through to the 40 or so underlying PIMCO funds Arnott employs in his absolute return strategies. Nevertheless, while only 11% of PIMCO's $573 billion in mutual fund assets can be traced to these two funds, their nearly $17 billion in inflows over the past 12 months accounted for close to a fourth of the firm's total inflows and about 30% of January 2013's estimated $9 billion in new money. Their popularity and impact on the firm are clearly growing.

Their appeal is obvious, especially these days. In some ways, they seem like perfect antidotes to the current anxiety-inducing, low-yield environment. That's particularly true for income-seeking investors who would rather keep equity exposure to a minimum. The two funds have delivered robust income streams and equitylike returns without equitylike volatility. In fact, through January both funds have beaten the world-allocation category average and the MSCI AC World Index by more than a percentage point annualized since their respective 2002-2003 inceptions. That's particularly impressive considering that equity exposure has rarely been much more than 20% of assets for either. That partly explains why they've also been among the category's least-volatile options. What's not to love?

Impact of One Customer
One potential problem with the funds' increasing size and popularity is the impact on the underlying PIMCO funds. As the two All Asset funds continue to grow, they become a larger share of the underlying funds' asset bases. While positions in individual underlying funds rarely consume more than 14% or so of the All Asset portfolios, even a 10% position across the two funds would claim more than $6 billion of a PIMCO fund's underlying asset base. That would be at least a fourth of assets of every PIMCO fund, with Total Return the sole exception.

But even that understates the impact. That's because of the leverage used by All Asset All Authority. Arnott uses leverage in that fund in an effort to add 1.5 percentage points of return over the long term. However, while leverage typically means more volatility, Arnott has used it responsibly thus far as All Asset All Authority has actually been the steadier of the two funds. That's partly due to the fact that he allocates a portion of the leverage to PIMCO StocksPlus Short Strategy PSSDX (9.9% of assets as of Sept. 30, 2012) as an offsetting hedge against the fund's equity exposure. Arnott used that fund to presciently take All Asset All Authority's net equity exposure to negative 5% of assets heading into 2011's tumultuous third quarter.

Nevertheless, All Asset All Authority's leverage increases its investable assets, adding to the potential strain on the underlying funds. At the end of January 2013, gross leverage stood at 24.6% of that fund's $31 billion in assets. This took the fund's investable asset base to $38.7 billion and the two funds' combined assets to $71.6 billion.

That's $8.5 billion more than the funds collectively held as recently as September 2012, the latest month for which PIMCO has disclosed individual positions. At that time there were 41 underlying funds between the two portfolios. The two All Asset funds accounted for more than 25% of assets for 26 of the funds. More strikingly, the duo claimed 75% or more of assets for 10 of the funds. (See the table.) This includes notable offerings such as PIMCO Emerging Markets Currency PLMDX and PIMCO Floating Income PFIDX. With the All Asset funds $8.5 billion larger four months later, some of those percentages have likely increased.

Furthermore, some of these relatively large positions are in funds whose underlying holdings in areas such as high-yield bonds and emerging-markets debt are themselves not terribly liquid. Exploding credit spreads during the 2008 crisis showed what can happen when liquidity evaporates from the high-yield market. Although emerging-markets debt generally fared better than high-yield in 2008, PIMCO Emerging Markets Currency lost nearly 15% as it was forced to liquidate holdings to meet heavy redemptions. (The fund has since made adjustments to its strategy to keep its portfolio more liquid.) As the All Asset funds continue to grow, it may become more difficult for Arnott to quickly reduce such positions, especially in the midst of a market meltdown. Or barring that, it may at least become more difficult for the All Asset funds to adjust position sizes without disrupting the underlying portfolios.

Long-Term Contrarian vs. Short-Term Trendy
However, Arnott sees that as an unlikely scenario. He prides himself on being a long-term, contrarian investor who wouldn't be inclined to sell under such circumstances. That philosophy has been one of the keys to his funds' success. Unfortunately, it's likely that not all the funds' shareholders share that philosophy, especially the newer ones who have been lured by the funds' plump payouts (both sported SEC yields above 4.5% as of Jan. 31, 2013). It should be noted that Arnott manages both funds for total return rather than income, but his valuation models have led him to put 50% or more of both funds in popular emerging-markets bond and high-yield bond funds lately. So, while he isn't necessarily chasing yield, that distinction may be lost on income-hungry investors.

Even so, Arnott doesn't fear the potential impact of mass redemptions. The funds themselves are well diversified across PIMCO offerings. He also says that liquidity is monitored closely across both the underlying PIMCO offerings and the All Asset funds. Based on internal stress tests, Arnott estimates that he could move $6 billion in a day under normal market conditions. Although the funds are far larger today, that's well beyond the funds' greatest prior one-day outflow of $250 million during the credit crisis. If redemptions picked up, he estimates that he could liquidate 30% of assets in a month.

Yet, as we've all learned since 2008, market stress can't always be accurately forecasted. And things can change quickly in the world of daily liquidity, open-end mutual funds. As many equity funds can attest (see American Funds Growth Fund of America AGTHX and Fairholme FAIRX), money can leave a fund even more quickly than it entered if expectations, realistic or not, are not met. Plus, All Asset All Authority's leverage introduces another potential wild card to the mix. (There's a reason why such leverage is rare in the open-end world.) And even if another crisis never materializes, the funds may have less flexibility as they continue to grow. Arnott himself acknowledges that tactical shifts could become more difficult to execute.

To be sure, liquidity and capacity are not imminent concerns for the funds. But  long-term asset growth of the All Asset funds is worth monitoring. It's difficult to say when a fund has reached capacity, but no fund's capacity is limitless, even ones so broadly diversified. 

Kevin McDevitt is an Editorial Director with Morningstar.
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