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By Jeremy Glaser and Michael Herbst | 09-30-2014 08:00 AM

Key Considerations for PIMCO Total Return Investors

Investors need to be aware of risks ranging from outflows to board stewardship, but the core investment process remains sound in the wake of Gross’ departure.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

In the wake of Bill Gross' departure from PIMCO, we've downgraded the firm's flagship Total Return Fund to Bronze from Gold. I'm here with Michael Herbst, our director of manager research for active strategies in North America, to take a look at this move.

Michael, thanks for joining me today.

Michael Herbst: Glad to be here.

Glaser: Let's talk about that Bronze rating. What does that represent, and why did we move it from Gold?

Herbst: In a nutshell, what this signals is that we have a high level of confidence in the managers who are taking over responsibility for the fund. But it also signals some very significant areas of uncertainty around the fund itself and around PIMCO as a firm, and also around the fund board quality, too, which we can touch on.

Glaser: Let's talk about what's staying the same and what makes you positive on the fund. What gives you confidence that it is going to continue to outperform?

Herbst: There are a couple of key things here that shape our thinking.

Scott Mather, Mark Kiesel, and Mihir Worah are taking over as leads on the fund. Scott Mather will ultimately be making the day-to-day decisions. These are managers that we're very familiar with. We've grown familiar with them over the past decade and watched their work at PIMCO. These are three highly accomplished, very experienced managers in their own right who have also built out very deep and strong teams around them, especially over the past five to seven years. That's one thing that gives us a great vote of confidence.

The second thing is the managers, in tandem with Group CIO Dan Ivascyn, all basically assumed oversight for the investment committee that's so central to the process at PIMCO. They assumed joint leadership of that committee in January, essentially sharing responsibilities for running that with Bill Gross at the time. So that is a key part of the process that essentially had already been up and running.

A third key part that is also intact at this point is the bottom-up expertise that will be feeding the fund. Mather, Kiesel, and Worah are also known for their bottom-up expertise, as is Ivascyn. ... These folks had been key contributors to Gross' bottom-up thinking historically, and now they just take on new responsibilities at the fund.

Glaser: On the flip side, though, what are the uncertainties. What makes you maybe a little bit less confident now than you were when Bill Gross was at the helm?

Herbst: That's a great point, and this is to highlight some of the issues that we're going to be watching in the days, weeks, and months going forward.

We do have a high level of confidence in the three managers that we spoke a little bit about, but they are taking on new responsibilities at the firm's flagship fund, which is undoubtedly headed into a period of turmoil, in some respects, if outflows pick up. A lot of people are trying to handicap what the flow situation at the fund is, as are we. We are comfortable with how the fund's portfolio could withstand outflows, at least in the near term. By our accounting, at least a third of the fund is in highly liquid securities; that's before you even account for cash. That's before you account for coupon payments into the fund as well.

That situation could change as we start to see flow data coming out of the firm in the days and weeks going forward. Everyone is trying to crack that, but from the news reports that we have seen, nobody has got a very close accounting for that. So that would be one level of uncertainty.

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