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PIMCO Battered but Far From Broken

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar's analysts have been re-evaluating PIMCO in the wake of Bill Gross' departure in late 2014. Joining me to discuss PIMCO's corporate culture in a post-Bill Gross world are two of Morningstar's lead analysts on PIMCO, Sarah Bush and Michael Herbst.

Sarah and Michael, thank you so much for being here.

Sarah Bush: Thanks for having us, Christine.

Benz: The team has really been digging into PIMCO from a lot of different angles since Bill Gross departed. I'd like to, as an overview, talk about that due diligence process and talk about the number of meetings that you and the team have had with PIMCO, as well as some on-site visits. What goes into creating an update such as this one and how does your ongoing due diligence process work?

Bush: In our due diligence that we do across all funds, we are regularly talking to managers and talking to leadership in the fund firms. We do on-site visits for a lot of the funds that we cover. We were out at PIMCO earlier this spring and had the opportunity to meet with senior folks both on the investment side and then also on the business side of the firm.

Benz: A follow-up to that would be that the managers and the other people running the firm really know some of Morningstar's hot-button issues. They know what we want to hear. How do you make sure that you're appropriately skeptical and you're not just being fed the information that you want to hear?

Bush: That's a very good question. It really is true that people know what you want to hear and you have to go into these conversations with a fairly skeptical approach. That said, I really find a couple of pieces very valuable when we have these conversations. In a case like PIMCO where there has been so much change in the senior leadership of the firm--not that they are brand new, but the overall structure has changed with Bill Gross' departure--having the opportunity to talk to them about their vision and how they are thinking about the investment process is really very valuable.

The other piece at PIMCO is that, obviously, a big part of our investment thesis at PIMCO is the sheer depth of the resources on the investment staff that they have there. They have something like 250 portfolio managers, all with a ton of experience. One of the things we have had the opportunity to do through our due diligence is get to know a lot of those folks farther down--the more junior- or intermediate-level investment staff. That really has increased our confidence and given us a higher level of confidence. We really can see the strength and the depth of this team. Talking to people, for instance, who are focused on financial securities in Europe and seeing the depth of the process they go through there really helps us feel comfortable with how that's all rolling up to broader-based strategies.

Benz: Michael, for people who haven't been following along as closely as you two and the rest of the analyst team have been, let's talk about some of the headline manager changes that have happened since Bill Gross departed--some of the changes on PIMCO Total Return (PTTRX), as well as some of the other funds that Gross was associated with.

Michael Herbst: We haven't actually seen the widespread changes or disruption that a lot of people might've expected. There have only been a small handful of senior-level departures since Bill Gross left. Saumil Parikh and Paul McCulley both left; but outside of that, you haven't really seen any of the major decision-makers leave.

Another thing that strikes us is Dan Ivascyn is really taking conscious steps to foster a more collaborative culture and a more open forum for communication--both within investment teams and across investment teams, too. That may seem like a subtle shift, but it's a powerful one. In our view, that's one of the most significant cultural changes from the Bill Gross-led PIMCO to the Dan Ivascyn-and-crew-led PIMCO as well. Some of that can be reflected in the comanager structure that they've implemented on PIMCO Total Return. We have Scott Mather making the ultimate day-to-day decisions but working closely with Mark Kiesel and Mihir Worah to run the fund. You have actually seen a number of other folks named as comanagers on other funds, too. So, that's far from just a cosmetic shift. That actually is a very serious, very conscious, very concerted effort, not just on behalf of Dan Ivascyn, but from all of the CIOs that we've been in touch with. This is something that they're fostering day in and day out, and we've seen it in the decision-making process driving the funds that they run.

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Benz: Let's talk about Dan Ivascyn. I think people might naturally be wondering who the new Bill Gross is at PIMCO. But it sounds like that's not quite the role that he wants to take on or that PIMCO necessarily wants him to take on. Correct?

Herbst: That's correct. There's no doubt about it--the lines of accountability at PIMCO are still very strong. So, ultimately, the buck will stop with the lead portfolio manager. In that respect, Dan Ivascyn plays a very prominent role. But he and the other CIOs that he has working with him would also be amongst the first to say that they basically grew up in the culture and in the strategies that Bill Gross had a huge impact in shaping. So, they are the first to give credit to Bill Gross for what he did. Again, the major change that we have seen--the move to a more collaborative structure--in some ways is a recognition of the folks who had played those prominent roles in the past. So, on the face of it, it may seem like a radical departure. And in some senses, it is a true departure from the Bill Gross-led PIMCO. But it's still the same firm. Virtually all of the folks there came up under Bill Gross, and his imprint is still very much indelible.

Benz: Sarah--Michael alluded to the fact that there have been a few departures. Paul McCulley may be a name that people know. Let's talk about those and whether those are concerning to you and the team--the people that we've actually seen leave.

Bush: After Bill Gross left, one of our big concerns, in addition to outflows, was the potential to see a hemorrhaging of investment talent from PIMCO, and that really hasn't happened. As you mentioned, there have been a few big headline names. Paul McCulley did leave, although it's very clear that he had come back to the firm earlier in 2014 at Bill Gross' request. And it was pretty clear from what we were hearing from PIMCO that he was likely to leave after the dust had settled a little bit. So, while he was certainly a huge contributor at PIMCO over the years, we didn't view that as a red flag. Saumil Parikh's departure was a little more notable and surprising. He had been tasked with heading up the firm's PIMCO Unconstrained strategy (PUBAX), which is one that I think they are very interested in having to be successful. However, he is one person, and the stability of the rest of the team has really been encouraging.

Benz: Michael, I was interested to read in the team's long-form discussion of PIMCO's corporate culture that, in some ways, you think PIMCO is culturally healthier than it was when Bill Gross was there. I'd like to discuss that. Also, in hindsight, do you think that the team should have been potentially a little harder on PIMCO when Bill Gross was running the show?

Herbst: There are a few signs that give us a sense that the culture may be healthier now than it was beforehand. With some of the philosophical shifts that Dan Ivascyn is leading that we talked a little bit about, we've actually seen the return of a number of senior-level personnel to the fold. Marc Seidner returned; Chris Dialynas returned. You've seen Dan Ivascyn take steps to support some of the portfolio managers like Mihir Worah and Mark Kiesel who are taking on additional responsibility. They've continued to invest in the investment team. They've hired roughly a dozen senior-level portfolio managers since Bill Gross left. They've made significant investments in the secular and cyclical forum process on the macroeconomic side.

So, this is by no means a firm in retreat. This is a firm where the leaders--also including president Jay Jacobs and CEO Doug Hodge--have been very vocal in their support for the folks at PIMCO. And they've backed up their words with some significant actions, significant retention packages. Again, you haven't seen wholesale departures from the firm. And to us, those are some aspects that suggest that PIMCO remains a firm that can attract and retain the best and the brightest. And in a sense, they might actually stand a better chance to do so now that one of its most contentious personalities is no longer in the mix.

Benz: The elephant in the room is the fact we have seen these huge outflows from PIMCO Total Return, also Unconstrained, Low Duration (PLDDX), High Yield (PHDAX)--a host of funds seeing huge redemptions. I know that you and the team, Sarah, have been watching their potential implications for the way those funds are run--are managers going to have to keep more liquid assets to meet redemptions? But also, there's the question of whether that is going to affect how the firm is run and how it interrelates with its parent company, Allianz. Let's talk about that issue and how you think redemptions may or may not affect PIMCO's culture and its fortunes.

Bush: When we started looking at outflows, as you suggested, we were watching how the fund was run. We also watched performance fairly closely--and performance has been solid. So, we're less concerned that outflows have had a huge impact there. When it comes to the firm, obviously PIMCO Total Return generated a huge amount of fees for the firm and for some of these other strategies as well. So, as those assets shrink, you are going to see less revenue and pressure on operating profits.

We have already started to see that from disclosures that Allianz has made. That said, PIMCO started off as a very profitable firm, so they had a fair amount of cushion as they went through this process. Also, there have been very clear signs that Allianz has been a supportive parent to PIMCO and understands that PIMCO needs to be able to continue to invest in its business in order to be prepared for the post-Bill Gross era. Michael mentioned the hiring of new staff; some pretty good high-level positions have been very encouraging.

So, while we continue to watch it, we don't think that the flows have come to the point yet where they're a problem. We also encouragingly saw a pretty big slowdown in flows in May. You don't want to ever say, "All clear," because if the fund really does have a period of sustained underperformance or if they have more manager departures, there still could be more outflows. It's an issue we are watching but still comfortable with.

Benz: You noted in your report that for 401(k) plans and other big institutional investors, you think maybe their work is done, in terms of pulling assets. Of course, a big shock to performance could affect that negatively, but you think maybe the worst is over from that standpoint?

Bush: So, PIMCO Total Return was a huge part of a lot of defined-contribution plans, and what we've heard from PIMCO and then also from some of the firms that have been seeing those inflows is that it really takes a long time for defined-contribution plans to decide to move forward to replace a manager and then to implement those changes. So, I think what we've heard from PIMCO and from other asset managers is that we seem to be at the tail-end of that for now, which is encouraging.

Benz: Michael, to sum up, say I'm an investor who has stayed in my seat through all of this--I have stuck with one of the PIMCO funds--going forward, can you give us an assessment of PIMCO's corporate culture and, in turn, how that affects Morningstar's view of PIMCO's stewardship?

Herbst: To weigh in on a question that you asked earlier, too--could we have been more critical of PIMCO in the past?--hindsight is 20/20. That's an open question. Perhaps we could have been. I think what had us cautiously optimistic even throughout 2014 is that they had moved to this co-CIO structure when Mohamed El-Erian left and also the depth of our knowledge of the firm and everybody backing those two personalities, Mohamed El-Erian and Bill Gross. That gave us a lot of confidence in the overall depth and the overall strength of the organization. Those were two of the things that were guiding our optimism. Could we have picked up on some of the red flags that started to appear during 2014? Yes. But the situation unfolded pretty quickly.

To answer the question of what we are thinking of, looking forward, at this point: We are, like we said, cautiously optimistic. There are a lot of positives here. PIMCO's leadership has done a very admirable job of steering the firm through the roughest period in its history. Also, we have a high level of confidence in the leadership of PIMCO, too. You haven't seen that much disruption on the investment front, which is a huge plus for investors in PIMCO funds. There are a handful of funds that we are continuing to watch closely. PIMCO Total Return and the Emerging Markets Bond fund (PEMDX) are some that we are keeping an eye on. But in general, things are going pretty well.

The open issues that we're keeping an eye on: We think a spike in outflows from here is a relatively low-probability event, but it could happen, which would change our view on the firm. If we saw other high-level departures, especially from the investment committee or at the CIO level, we would dig into that in earnest. If performance for any of the strategies went off the rails, that's probably the thing that we're watching most closely, day to day and week to week.

Is PIMCO out of the woods? Not yet. Are there a lot of encouraging signs that they are battered but not broken? Most definitely.

Benz: Thank you so much for being here. Obviously, a lot of insights have gone into preparing this report--a lot of due diligence behind the scenes. Thank you so much for sharing your insights.

Bush: Thanks very much, Christine.

Benz: Thanks for watching. I'm Christine Benz for