Morningstar's Recommendation on PIMCO Funds

The recent allegations made by the attorney general of New Jersey against some firms falling under the PIMCO banner are messy. After carefully scrutinizing both the complaint and its numerous exhibits, Morningstar's editors and analysts have elected to recommend the following. We suggest that investors consider selling funds run by PIMCO Equity Advisors, while we have elected to make no changes to our opinion of PIMCO, the fixed-income operation, based on these specific allegations and exhibits provided in the complaint.

The issues here are especially complicated because the corporate structures under which all of those firms fall are not easily untangled. (They're all subsidiaries of German insurance behemoth Allianz (AZ).) That in itself is a cautionary tale. As companies like Allianz grow, acquire, and affiliate themselves with others, there's an increased risk that the drive to placate different cultures will spawn an organizational structure that’s too unwieldy to provide accountability. This sets the stage for transgressions that are embarrassing, or worse.

That's arguably what's happened here. PIMCO Advisors Distributors (also known as PAD) is a subsidiary of Allianz that has responsibility for distributing, or more basically, selling, all of the funds that have "PIMCO" in their name. Under that umbrella are a large number of money managers of varying sizes and styles, all of which operate semiautonomously under different names. These include PIMCO Equity Advisors (also known as PEA Capital, or PEA) and Pacific Investment Management Company (PIMCO), the crown jewel whose name has been appropriated for branding purposes.

The New Jersey complaint makes allegations that touch all three of these firms--PAD, PEA, and PIMCO. The charges involve numerous employees and assert wrongdoing of various depths.

PIMCO Equity Advisors
The allegations against funds run by PIMCO Equity Advisors (whose funds all carry "PEA" in their name), and the evidence provided, are in our opinion, extremely troublesome. As noted, we therefore suggest that investors in those funds consider selling them. Before doing so, however, one should be sure to evaluate potential commission and tax costs of any trades. In addition, participants in 401(k) plans should be careful before dumping a fund if it is their only way to gain access to an important asset class. We strongly encourage investors to review the complaint upon which our recommendation is based.

The case against PEA asserts that, like many other firms, it entered into agreements with the hedge fund Canary Capital to allow the latter to market-time its funds. Importantly, the allegations also include an assertion that PEA allowed Canary to market-time certain funds if Canary agreed to invest long-term or "sticky" assets in other PEA funds or hedge funds.

PEA has responded by saying that the fund officials responsible for setting up the timing agreements were led to believe that Canary's approach was part of a fundamental investment strategy rather than an attempt to market-time. A spokesman for PEA has also asserted that what have since been coined "sticky assets" were characterized by Canary as nothing more than the long-term portion of Canary's portfolio strategy. Fund officials also have argued that the standard applied by executives of the firm was one of preventing harm to shareholders, and that they carefully monitored Canary's trading to prevent that eventuality. They cite their decision to halt Canary's activities in late 2002 as evidence of their vigilance. Moreover, fund officials note that while the fund's prospectus gives the firm the right to restrict trading beyond a certain level, it does not obligate it to do so. Finally, the firm's distributor says it began the process of implementing short-term redemption fees some 18 months ago.

We've reviewed the New Jersey complaint and all of its exhibits carefully, though, and don't agree with PEA's assessment. It seems quite clear that the firm had a sticky-asset deal that amounted to the sale of timing capacity in exchange for Canary's willingness to park money in other funds. Moreover, we take strong exception to the firm's liberal reading of its prospectus language. The document very clearly suggests to investors that those making more than six trades per year will be scrutinized and ejected from the funds. The firm, however, essentially viewed that as a guideline, and while it saw fit to deny access to other timers, PEA's executives penned a deal with Canary to allow four trades per month in exchange for the placement of sticky assets. From our point of view, that's a blatant violation of the spirit of the funds' prospectus. As such, PEA's assertion that some funds actually profited from Canary's actions, while the harm to another was minimal, doesn't change our opinion of the firm or its actions.

This transgression only further weakens the already shaky thesis for owning PEA's funds. While a few of the firm's offerings are standouts, the lineup hasn't impressed on the whole. In particular, its growth-oriented offerings have had spotty returns. Performance aside, perhaps the gravest indictment of the firm is chief investment officer and portfolio manager Ken Corba's apparent involvement in the timing incident. Indeed, Corba appears to have played a central role in setting up and shepherding along the timing deal with Canary. And while Corba eventually grew alarmed that Canary's timing was becoming too aggressive and potentially harmful, that concern came only after Canary had blown by both the funds' prospectus limits, and the timing agreement he helped create. Based on the evidence presented in the complaint, we believe that Corba clearly put the interests of PEA Capital ahead of those of its investors. Until the firm takes steps to dispel the doubts that this episode has cast over PEA’s commitment to shareholders, investors are better off taking their business elsewhere.  

PIMCO
The case presented specifically against the California-based PIMCO, which manages billions of dollars in bond money, appears less compelling. In essence, the complaint centers around an agreement between marketing executives at PIMCO and Canary Capital for the latter to make no more than one round trip trade per month in PIMCO's funds. The crux of the complaint is that PIMCO was therefore willing to overlook the stipulation in its prospectus that investors would not be allowed to make more than six round-trip trades per year. We don't believe that these charges are nearly as conclusive as those made against PEA, though.

What the New Jersey attorney general purports in its complaint to be damning evidence appears much less so in the exhibits provided. More than once, for example, the complaint states in no uncertain terms that PIMCO specifically agreed to allow Canary up to 12 round-trip timing trades per year. In fact, the exhibit from which that assertion is drawn says only that Canary will make no more than one round-trip trade per month, with no mention of a maximum allowable number of trades per year. To be sure, that lack of detail is troubling, and there's no question that PIMCO's employees should have been much more specific about what the prospectus rules allowed. Still, the complaint seems to be reaching too far to try and illustrate malfeasance without the necessary evidence. In another section, the complaint appears to insinuate that a PIMCO executive suggested spreading trades across four accounts, ostensibly in order to hide the source of timing activity. That kind of suggestion could lead one to believe that the author, a PIMCO employee, knew that the activity was wrong and therefore required concealment. The letter in question, however, which was later provided alongside the complaint, contradicts that characterization, as it specifically requires that the money in question come from "4 separate clients."

The complaint also cites a large number of trades and dollar amounts that were moved in and out of PIMCO's funds as evidence of impropriety. PIMCO claims, however, that the methodology used by the New Jersey attorney general creates the appearance of more trading than actually occurred, by breaking out each so-called "round trip" trade into multiple legs. When the firm went back and reconstructed the trading activity, it determined that no more than five round-trip trades were made in a single year. It's impossible to say which interpretation is the correct one based on the information provided, but PIMCO's account of the trading activity would appear to reflect compliance with the PIMCO prospectus. That obviously isn't the end of the story, as it’s the presence or absence of intent to violate the prospectus that concerns us, but if PIMCO's account of the facts is correct, it does support the firm's assertion that its employees tried and were able to keep a lid on Canary's activities.

The strongest piece of evidence in PIMCO's favor, however, is provided right in the New Jersey complaint. At one point a marketing executive at PIMCO sent an e-mail to confirm the end result of a conversation he had with a Canary representative. In that message, he specifically noted that he would be sending a copy of the fund's prospectus "…so that the full details of our policies are readily available to you." We remain concerned that Canary's overtures weren't properly handled at the onset, but whatever PIMCO's previous lack of clarity, it would appear that this message was intended to make certain to Canary that the firm would have to stay within the limits of PIMCO's prospectus.

As has also been the case with our evaluation of other firms implicated in trading improprieties, we've also factored in the quality of PIMCO as a firm before the allegations of improper trading surfaced. On that score, PIMCO fares quite well. The firm has a relatively long history of excellent management and a shareholder-friendly management style. The firm's  PIMCO Total Return Fund (PTTRX) was one of the first contrary icons to face down a bond-fund industry that otherwise made its fortunes on the back of yield-hungry strategies that were great for selling funds, but much less so for protecting investor principal. One can reasonably disagree with PIMCO's methods, such as the liberal use of macroeconomic bets and complex derivatives. The outcome has been extremely beneficial to shareholders, though. And notwithstanding relatively high expense ratios on PIMCO's retail share classes, the fund's institutional shares have brought topnotch institutional-style bond management to numerous investors, particularly through 401(k) plans. And while PIMCO cofounder and Total Return manager Bill Gross has often been accused of hamming for the media spotlight, he has also been unafraid to take on conventional wisdom and industry untouchables.

To be sure, there are elements of the complaint against PIMCO that are unbecoming. One would frankly hope that anyone approaching the firm and even breathing the term "market-timing" would have been shown the door without delay. But while some PIMCO employees appear to have used poor judgment in their dealings with Canary, that group did not include any of PIMCO's senior managers. It's also reassuring that at least one employee eventually had the sense to clarify the fact that prospectus rules would govern the relationship.

Conclusions
Overall, we remain disturbed that PIMCO Advisors Distributors (PAD) appears to have helped facilitate market-timing arrangements, because PAD distributes all funds that carry the PIMCO label. It's true that firm shares no executives with any of the Allianz subsidiary firms that actually manage money under the PIMCO name, and none of PAD's employees report to executives of those firms. So-called "profit and loss" responsibility for PAD is completely separate, as well. Importantly, though, PAD is responsible for policing the activity of market-timers for all of the retail share classes of the various funds under the PIMCO name (essentially those classes designated by letters), and in many cases is the only unit of Allianz able to see, and thus police, the transactions of individual shareholder accounts.

That's critical because the evidence presented in the New Jersey complaint strongly supports the notion that PAD executives were well aware of the timing arrangements at PEA Capital, and were sought out to provide approval of those activities. By extension, and of critical importance to PIMCO shareholders, is that PAD executives would have also been in a position to approve market-timing activities in PIMCO's bond funds. Bill Gross has recently been vocal about these corporate relationships, declaring that he would seek a "divorce" separating PIMCO's fixed-income operation from other Allianz subsidiaries. We strongly agree that action is necessary in order to maintain the appeal of the rest of the lineup of PIMCO branded funds.

There are numerous paths for PIMCO to take. As Gross has already suggested, it may be possible for the California firm to sever its relationship with PAD, and either hire a different distributor or completely bring the supervisory functions of fund distribution in-house. Alternatively, the firm might choose to lobby Allianz to effect dramatic changes within PAD, including the removal of executives who have shown a willingness to compromise the interests of shareholders. Whatever major changes ensue, we believe that PIMCO should act swiftly to strengthen its internal compliance procedures and to ensure that any future questionable client activities or requests are brought to the attention of the firm's senior officers and handled in the best interest of shareholders. Gross has been vocal in recent years about avoiding investment decisions that could irrevocably harm shareholders and the PIMCO name. It should be clear to all involved at the firm that this line of thinking must also apply to the everyday conduct of its business and the ethics of its employees.

Because PIMCO is owned by Allianz, and because changes to its distribution agreement apparently require action on the part of its fund board, change with regard to PAD may not be instantaneous. The firm has explained in detail that it is a separate entity from PAD and PEA, both legally and in day-to-day practice. We're inclined to believe PIMCO, but failure to act expeditiously on the part of PIMCO would undermine that assertion, and imply that the difference among the three firms is more cosmetic than real. If we don't see significant progress on one of the aforementioned tracks--either severing the PAD relationship or removing the executives responsible for the timing agreements--in a very short timeframe, we will reconsider our stance on the PIMCO funds overall. For now, though, our opinion of the PIMCO funds not managed by PEA remains unchanged.