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Morningstar's Current View on PIMCO

Still formidable, with areas for improvement and a few open questions.

Eric Jacobson and Michael Herbst, 03/18/2014

On Jan. 21, 2014, PIMCO announced that former CEO and co-CIO Mohamed El-Erian would be departing the firm by mid-March 2014. Those announcements took most PIMCO observers by surprise. The firm announced a number of additional changes to its leadership ranks on Jan. 29, 2014.

Since those announcements, a number of media articles have focused on the fractious interactions between CIO Bill Gross and El-Erian; short-term performance challenges and outflows at a few of the firm's funds; and Gross' at-times tempestuous behavior. Those articles generally did not directly address the question of whether El-Erian's departure, Gross' behavior, or the recent leadership changes have actually impaired or benefited PIMCO's investment process and investment culture.

We've been delving into that question in a series of extensive conversations with PIMCO's leadership. Since the changes were announced, Morningstar analysts have been in frequent contact with PIMCO's senior leadership, including Gross, Mihir Worah, and other portfolio managers directly or indirectly affected by the changes. We've also had extensive conversations with other members of PIMCO's leadership, including CEO Doug Hodge. These conversations culminated in an on-site visit to PIMCO on March 10, 2014.

Given our current view, we have lowered PIMCO's overall Stewardship Grade to C from B, with an A grade being the highest possible and F the lowest. We have also lowered PIMCO's Parent Pillar score--one of the five pillars of the Morningstar Analyst Rating for Funds--to Neutral from Positive. Those changes reflect a higher degree of uncertainty around the firm's recent personnel changes and lower manager investment alongside fund shareholders.

The changes to PIMCO's Stewardship Grade and Parent Pillar score do not automatically affect PIMCO funds' overall Morningstar Analyst Ratings for Funds, yet it is logical to assume that Morningstar analysts would move quickly from here to reassess those ratings on a fund-by-fund basis. We are preparing a follow-up piece for early April 2014 that will summarize our current opinions on individual PIMCO funds. In that piece we'll also answer a number of PIMCO-related questions that we have been receiving most frequently from investors.

What follows below is essentially the Corporate Culture section of our updated Stewardship Grade on PIMCO. We've also attached a PDF containing a brief synopsis of what happened at PIMCO, Morningstar's response thus far, and the full scoring and text of our updated Stewardship Grade on PIMCO.

Slowly Heating Water
In many ways, PIMCO has long had a standout corporate culture. Bill Gross is the founder around whom PIMCO was built, and his essential nature as an investor, above all else, has been a critical foundation for the firm.

The firm's public reputation was shaken in January 2014 following the announcement of Mohamed El-Erian's March departure. Much of what was publicized after that announcement can arguably be viewed as tabloid fodder, but his resignation, combined with other departures in recent years, has helped drive material changes in PIMCO's corporate culture.

In the years leading up to El-Erian's exit, the firm had experienced a number of other changes in its senior investment leadership. Two under-the-radar departures occurred in 2008 and 2009, for example, when Pasi Hamalainen retired and Zhu Changhong was recruited by the Chinese government to run its then-$2.5 trillion in foreign-exchange reserves, respectively. Neither Hamalainen nor Zhu's name was attached to high-profile mutual funds, but each had been a member of PIMCO's Investment Committee (then an even-smaller, more exclusive group than it has since become) and had been widely considered to be a valuable contributor to the firm's investment strength in his own right.

Veteran generalist manager Bill Powers left the firm in 2010, and, although his focus on institutional accounts meant he wasn't well known to mutual fund investors either, he, too, had been a very senior member of the Investment Committee. Another former member of that group, Paul McCulley, held tremendous responsibility as watcher-in-chief of the world's central banks, leader of the firm's cyclical economic forums, and head of PIMCO's short-term bond desk, before he retired at the end of 2010. There were other notable departures of successful managers over the same years, including those of high-yield desk leaders Ray Kennedy (2007) and Mark Hudoff (2009), Treasury Inflation-Protected Securities luminary John Brynjolfsson (2008), global-bond specialist Sudi Mariappa (2011), and government-mortgage maven Scott Simon (2013).

The last very senior-level member of the Investment Committee other than El-Erian and Gross, long-tenured PIMCO veteran Chris Dialynas, made a November 2013 announcement that he would be taking a sabbatical beginning in early 2014. Whether temporary or not, Dialynas' loss is especially notable given his reputation as something of a "glass-half-empty" kind of guy in contrast to--and as an important foil to--Gross, who sees himself as more of an optimist when looking at economic and investing landscapes.

Morningstar had weighed the potential impact of each departure over the past six-plus years. And while some were more worrisome than others, PIMCO has always had a deep enough bench to withstand the changes; that confidence in its staffing, and in Gross, has historically proved to be well placed.

It's Not the Emergency It Might Initially Seem
El-Erian's departure was clearly a game changer for several reasons, though. Most obviously, he was Gross' hand-picked and named successor, suggesting that he would likely take over as sole chief investment officer whenever Gross was to step down. Furthermore, his departure, coupled with the uncertainty surrounding Dialynas' return, meant that no single remaining member of the Investment Committee had the kind of senior-statesman profile of those who had departed in recent years. Meanwhile, El-Erian protege Marc Seidner, who had taken on increasingly greater responsibilities during his tenure at the firm, announced his own departure from PIMCO immediately after El-Erian's was made public.

That litany of defections may look alarming when assembled in a single narrative, but it is arguably less of a worry than it might seem. PIMCO's case for depth is compelling, boasting more than 240 people in portfolio management roles around the globe, and among them more than 70 considered key contributors with a median average of roughly 17 years of experience. In addition, PIMCO's demonstrated history of picking leaders to fill in for those who have moved on suggests the firm has proved to have an uncanny ability to thrive in the wake of key personnel losses.

In the wake of El-Erian's resignation, the firm appointed six deputy chief investment officers, three of whom--Mark Kiesel, Dan Ivascyn, and Mihir Worah--were concurrently added to the Investment Committee. New deputy CIOs Andrew Balls and Scott Mather were already on the committee, while equity-group leader and newly named deputy CIO Virginie Maisonneuve effectively became an adjunct member. At the same time, central-banking maven Tony Crescenzi, who, like colleague Saumil Parikh, took over important roles following Paul McCulley's retirement, also joined Parikh and the others as a full-time member of the committee. PIMCO has said that the appointment of new deputies was actually an idea developed and championed by El-Erian before he stepped down.

Is It Just New Players, or a Different Game?
That new blood brings much more than fancy new titles to the table, and each member of the Investment Committee brings a resume of impressive accomplishments. Like Parikh's, Crescenzi's name became more well-known following McCulley's retirement, and he already had more than 30 years of experience and five books under his belt. Worah's star had already been shining as well, with impressive results from PIMCO Real Return PRRIX and other inflation-protected offerings. Balls' reputation has revolved a great deal around his knowledge of and experience with global economics, while Mather has shone with excellent performance records at several, mostly global-bond-focused portfolios. Meanwhile, Mark Kiesel and Dan Ivascyn have each taken home a Morningstar Fund Manager of the Year Award: Kiesel for his work on PIMCO Investment Grade Corporate Bond PIGIX in 2012 and Ivascyn for his work on PIMCO Income PIMIX in 2013 with comanager Alfred Murata.

From the perspective of PIMCO's culture, the biggest question about this chain of events is whether the atmosphere within which the firm's current Investment Committee and broader investment team work will remain conducive to its success. That atmosphere has long been characterized as a pressure cooker, yet it remains an open question whether the current Investment Committee members--several of whom are a bit less seasoned than their predecessors--will consistently voice their opinions and fuel the debate that has been crucial to PIMCO's past success. That may prove daunting, given Gross' at-times severe and reputed retaliatory temperament.

Even so, PIMCO's power structure looks very different in the wake of El-Erian's resignation. The firm has strong and capable corporate leaders in the form of CEO Doug Hodge, president Jay Jacobs, and six very capable deputy CIOs. In addition, by his own account, Gross has acknowledged that he understands the risk an unhealthy culture can pose to the organization and concedes that PIMCO has room to improve. He has thus taken concrete steps to encourage greater dialogue and debate within the Investment Committee: In a break from the past, each of the deputy CIOs is charged with leading committee meetings on a rotating basis, so Gross heads only one meeting in every rotation. In addition, each of the new deputy CIOs now oversees several portfolio managers and, by extension, all of the specialist desks and the assets for which each skipper is responsible, thus taking on most of the personnel management duties that had previously fallen on El-Erian.

More of the Same or Are Changes Afoot?
It's crucial to note that PIMCO's essential investment process remains at the core of everything the firm does. The tone was set early on by Gross, who favored a total-return approach to bond investing, which has since become de rigueur but that was novel as recently as the early 1990s. Those investing with Gross have often found themselves looking at comparatively modest income payouts but total returns that have almost always been much better than average.

Although the complexity of PIMCO's strategies, tactics, and favored investing tools often lends an aggressive flavor, a fierce attention to risk is built into the firm's investment and operational processes. The workings of PIMCO's Investment Committee illustrate the relationship between its approaches to performance and risk control. The committee typically meets four times per week, for hours at a time, to debate matters of the market and economics. Other colleagues are invited to come to present ideas, while some rotate through for stints on the committee in order to encourage a diversity of views. PIMCO outsiders are also brought in to make presentations, and managers are given incentives to second-guess the Investment Committee.

In theory, dialogue within the Investment Committee may be more open than it had been prior to El-Erian's departure, but it will take time to determine whether PIMCO's recent leadership changes and Gross' apparent change of heart will truly produce better investing outcomes.

Meanwhile, there remains a process in place to replace Gross as CIO when the time comes, and he believes that the most likely candidates are those now filling PIMCO's deputy CIO roles. The firm isn't likely to name anyone as an intended successor, however, before the need actually arises to appoint one, and it seems in the realm of possibility that competition for the slot could prove contentious. Other important questions, of course, are whether any of those newly appointed folks would even be a good fit for the role and whether any would be ready to take over from Gross should that need arise much sooner rather than later.

Other Issues On the Radar
There are, of course, plenty of other issues relevant to PIMCO's culture. The firm has been more prolific in its rollout of new funds in the past few years, for example, and, despite its very anemic record with new equity-focused offerings in particular, the deliberate style with which the firm has done so has been, and continues to be, indicative of a mostly investor-friendly culture. PIMCO does not have a record of rolling out niche funds simply to take advantage of popular trends. Rather, most have been driven by ideas and developments in institutional management or, in some cases, developments in financial markets that have made one strategy or another newly feasible.

One area with which Morningstar continues to harbor some concern is size. Even in the wake of notable redemptions in 2013, PIMCO Total Return PTTRX still comprised more than $235 billion in investor assets as of February 2014 and remains the world's largest actively managed mutual fund. Meanwhile, Gross himself manages approximately $470 billion. That girth has by Gross' own admission made managing Total Return more challenging, though the redemptions appear to have neutralized some of the past focus on its size, and he points to long-term performance as the ultimate measure of that question. That's a credible claim despite the fund's size, given that it has been the largest or among the largest bond funds in existence for a long, long time, and its long-term risk-adjusted record has remained strong.

Even despite PIMCO's 2011 and 2013 stumbles, it's clear that Gross has adapted better than almost any other manager ever has to massive asset growth, certainly among bond funds, and there's scant evidence to suggest that those years' setbacks had anything to do with limitations from the firm's size. Gross' command of big-picture macroeconomic and sector themes has been at the root of that success, especially as PIMCO's size has expanded. Whatever the image that his latest personality tribulations have projected in the wake of El-Erian's departure, there remain good reasons to believe he can persevere and his success persist.

Even at its modestly reduced asset base, however, the impact of Total Return's size remains an issue that Morningstar continues to study and examine. Meanwhile, many investors have raised the question of how that fund would fare should redemptions spike back up to their 2013 pace or worse. Given the way that Gross has managed the portfolio in recent years, though, investors have good reason for confidence. He has traditionally focused plenty of fund assets in very, very liquid securities, including Treasuries, agency-backed mortgages, and even cash. Gross notes, in fact, that between bond interest payments, mortgage principal flows, bond maturities, and calls, so much cash comes in every day that meeting even the sizable redemptions from 2013 was an easy exercise.

In the meantime, there are other in-house examples of PIMCO funds whose size does raise even stronger questions about the firm's unwillingness to close large funds. Even with a smaller portfolio than it boasted a couple of years ago, PIMCO High Yield PHIYX, with more than $15 billion in assets as of February 2014, is the second-largest chunk of fund assets in the category if combined with $3.3 billion sibling PIMCO High Yield Spectrum PHSAX, and PIMCO manages additional high-yield assets in other funds and institutional accounts. Unlike Total Return, whose fortunes are more tied to macroeconomic and sector calls, these two funds are arguably much more dependent on bottom-up research and bond-picking--the kind that becomes more and more difficult to execute at a high level when a fund's size minimizes the impact of the smaller deals that dominate the at-times illiquid high-yield sector. The question for such funds is whether PIMCO sacrifices the interests of existing shareholders in favor of its own growth of assets under management.

If there is one element of the size question that really gives reason for pause, though, it's the question of what might happen should PIMCO's overall business shrink, whether as a result of a loss of confidence in the firm or even simply a trend of investor rotation away from the fixed-income markets that dominate its business. That's a much more difficult puzzle to assemble given the many possible paths the situation could take and the variety of potential responses from the leadership of PIMCO or even Allianz. It's a near certainty, however, that a sustained reduction in the firm's assets under management could trigger staff reductions and potentially make it much more difficult to retain talent. It's another element of the story that Morningstar will certainly continue to monitor.

Dollars As Well As Sense
Arguably just as important to PIMCO's Corporate Culture grade is the cost picture for investors in PIMCO's noninstitutional share classes, in particular. Several are priced high relative to similarly structured peers and sometimes emphatically so relative to the economies of scale that the firm enjoys. It's difficult to pin down why this issue has failed to gain more attention within PIMCO, particularly given Gross' occasional public comments about the headwind of high fund costs--in a 2009 column he referred to 0.75% bond fund expense ratios as an "extreme absurdity."

Other PIMCO representatives have offered that the world-class caliber of its management is ample justification for its fees. There is some merit to that argument, but PIMCO's noninstitutional share classes sometimes carry fees that are simply too high to recommend, no matter how good the management. And even then, while the funds' institutional shares are competitive on a relative basis with their various cohorts, they tend to lack fee breakpoints--Total Return is a glaring example--and charge a lot more than one might expect given their size. Of all the funds in the marketplace, this enormous portfolio should by all rights boast a truly low expense ratio in its peer group. And that's really the ultimate issue, especially for a fund group that has some of the best economies of scale of any in the world.

There's no question that PIMCO's overall culture and what it has produced for investors deserve significant recognition. On some levels, this firm still approaches or achieves best-in-class status. The aforementioned cost and asset size issues, however, have been enough to keep it from earning Morningstar's highest grade for some time. And despite all of the reasons for optimism, there is a heightened level of uncertainty in the post El-Erian era surrounding the questions of whether PIMCO's latest senior staffing transitions will prove beneficial to investors; whether recent and future senior-level departures indicate a persistent side effect of the firm's pressure-cooker culture; whether that culture will improve or turn out to be malignant for PIMCO's rising stars; and even whether the prospect of rockier bond markets or anemic performance could cause the temperature to rise even further. Those areas of uncertainty, combined with the aforementioned cost and size issues, push down PIMCO's Corporate Culture grade to Neutral.

Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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