You Wanted Bill Gross? You Got Him.

 PIMCO Unconstrained Bond (PUBAX) gets a new and familiar face, but there are no plans to change its personality.

On Dec. 5, 2013, PIMCO announced that skipper Chris Dialynas will begin a sabbatical in March 2014 (likely for a year) but that he would immediately depart this fund. His replacement is Bill Gross, PIMCO's co-founder, co-CIO, and manager of  PIMCO Total Return (PTTRX).

There is precedent for Dialynas' sabbatical--he took a long one in the mid-1990s--but it's fair to question whether the firm was looking for an opportunity to change the fund's leadership. It has delivered on its promise of low volatility and reasonable absolute returns (its Institutional shares edged out the Barclays U.S. Aggregate from inception through Nov. 30, 2013), but it has disappointed some investors by lagging PIMCO Total Return and the nontraditional bond category average overall.

It's not fair to point the finger only at Dialynas, though. The fund's positioning prior to the summer 2013 sell-off, which included meaningful exposure to market laggards such as emerging markets and municipals (and a stash of Treasury Inflation-Protected Securities), was wholly consistent with the biases of other PIMCO funds and the firm's investment committee.

More broadly, investors have arguably been confused by PIMCO's dual emphasis on its unconstrained label and absolute return mandate. The former, complemented by broad discretion to manage duration and sector bets, has led many to expect PIMCO's "best ideas" to generate tactical moves and excess returns that would beat those of its Total Return offering. Yet the firm has also run the fund as an absolute return vehicle, emphasizing its defensive interest-rate posture and modest volatility relative to core offerings. There's a natural tension between those ideas, though, and it's difficult to meet low-volatility expectations while producing fat returns.

PIMCO says there are no changes planned for the fund, but Gross admits that Dialynas is probably more conservative than he is. It will be worth watching to see whether that difference manifests itself here in more-aggressive bets, higher returns, more volatility, or all of the above. For now, at least, it's hard to argue against more attention from Bill Gross; the fund therefore retains its Bronze Analyst Rating.

Process
This portfolio is in some ways the most extreme representation of PIMCO's overall investment process. Although the fund reports its results against benchmarks as all funds do (in this case, primarily 3-month Libor), its positioning isn't linked to that of an index.

Overall, the process involves drilling down from PIMCO's major secular and cyclical economic themes, followed by the incorporation of the firm's market views and portfolio targets, and the implementation of portfolio-level decisions. The process involves a combination of macroeconomic forecasting (supported by PIMCO's investment committee) and bottom-up analysis (supported by PIMCO's sector specialist desks) to determine interest-rate, yield-curve, currency, country, sector, and individual issue-level decisions. From an interest-rate perspective, the fund has broad freedom to work inside a duration range of negative 3.0 to 8.0 years. It can also invest up to a maximum 40% in high yield and a maximum 50% in emerging markets; it will normally limit its investments in non-U.S. currencies to 35%.

In practice thus far, however, previous manager Dialynas and PIMCO's investment committee have both played a cautious game that has resulted in low volatility relative to similar funds and longer-term returns that have been close to those of the Barclays U.S. Aggregate Bond index, but which have also been average or below average relative to the nontraditional bond category.

Given PIMCO's staffing and resources, the fund's exhaustive process could actually produce an overwhelming set of portfolio choices. That process involves culling each specialist manager's five to 10 best ideas, though, and sizing those bets based on expected returns under different scenarios. The goal is to get the most return per unit of volatility, while focusing on those with the highest likelihood of producing positive returns, rather than executing a strategy focused on avoiding tracking error relative to a benchmark.

And while PIMCO has been ratcheting back risk across most of its funds over the past couple of years, this fund's flexibility still translates into a lot of moving parts. As of Oct. 31, 2013, for example, it included contributions from more than 21 different subsectors. Beyond cash and money market futures (56% of assets) and government-related debt (24%), the fund's largest net positive exposures were in emerging markets (11%; less than half its level from a couple years ago), investment-grade credit (8%), nonagency mortgages (10%, including a 2% slice of commercial mortgage-backed securities), and even municipals (3%).

All of the fund's underlying long exposures together added up to more than its overall 0.87 years of duration as of October, but the fund used other instruments such as interest-rate swaps to create short exposures. Notable among them were effective shorts on Treasuries and non-U.S. developed-markets bonds.

Performance
The fund defied the fates of several PIMCO siblings in 2011, which suffered from too little exposure to the Treasury market and the rally it enjoyed that summer. This fund was net short Treasuries at the end of August 2011 but fared better than many other nontraditional bond funds. Several were more heavily invested in high-yield and non-U.S sectors that sold off sharply with equity markets.

In general, the fund has kept interest-rate sensitivity low and focused mostly on credit sectors. That worked well in 2012, as it gained 9% and placed in the best third of the peer group. Its nonagency holdings were particularly helpful, while investment-grade financials and emerging-markets debt contributed much to the fund's success.

The fund hasn't been perfect. It carried a modest 1.4-year duration (April) going into 2013's summer sell-off and had expressed caution with a complex option. The option required a sell-off in both interest rates and the S&P 500, though, and it wasn't triggered. Meanwhile, the fund's emerging-markets positions (Brazil, in particular) suffered; the fund fell 4% from early May through August and placed in the category's bottom half for the year through Dec. 18.

Overall, the fund may not be meeting the expectations of those who had envisioned top-shelf returns, having turned in modest gains relative to other nontraditional bond funds. It has arguably lived up to its absolute return promises, though, topping the Barclays U.S. Aggregate over the long term, producing less volatility than that index and its category, and all while generally taking on less credit risk than many competitors.

People
Dialynas had been the named portfolio manager here since the fund's June 2008 inception, though as noted, he stepped down on Dec. 5, 2013, in anticipation of a sabbatical beginning in the second quarter 2014.

Dialynas' successor, Gross, has been Morningstar Fund Manager of the Year three times and is Morningstar's reigning Fund Manager of the Decade (the 2000s) for bond funds. Once a bond-by-bond picker of corporate-debt securities, Gross' expertise evolved over the past 40 years, and today he is a titan in the world of investing across fixed-income sectors such as mortgages, corporates, and governments.

Gross is supported by portfolio managers Saumil Parikh and Mark Seidner, generalists who also sit on the investment committee, and Mohit Mittal, who runs investment-grade credit and other unconstrained portfolios, and sits on PIMCO's Americas Portfolio Committee. Parikh leads the firm's cyclical economic forums and is a member of the short-term, mortgage, and global specialist teams. Prior to joining PIMCO in 2000, he worked as a financial economist and market strategist at UBS.

Seidner came to PIMCO in 2009 from Harvard Management Company--where he worked with PIMCO co-CIO Mohamed El-Erian--and before that Standish Mellon and Fidelity. He has 23 years of investment experience.

Parent
PIMCO boasted nearly $2 trillion in assets under management as of September 2013. The firm has been dominated by Gross since its founding and has long employed some of the most complex tools in its portfolios, producing some of the industry's best results.

One of the keys has almost certainly been Gross' decision to stay on the investing side of the business without distracting himself with CEO duties. That has translated to an investment culture that has survived the firm's growth and expansion. Gross' singular influence has a flip side, though, in the form of key-man risk. PIMCO does have a deep bench to take up the slack in the event that Gross were to leave. Few other skippers have shown a yen for managing as much money as Gross, though. It's also unclear whether investors might choose to leave PIMCO in his absence.

Meanwhile, PIMCO does have blind spots. The growth of its flagship Total Return offering has made Gross' job more difficult. The fund has maintained a strong record, but it remains unclear if and when the portfolio's size might take its future success beyond the realm of difficult to prohibitive. Costs are an issue for PIMCO investors, too: The average percentile ranking of expenses across classes is 49. That number could be better given the enormous size of the firm's asset base.

Price
It's common for firms managing funds of this type to argue that they warrant higher expense ratios given their specialized mandates and high pricing among hedge funds that do similar things. The arguments are often specious, though, and this fund's 0.90% Institutional share price tag has already proved a high hurdle for a fund with relatively modest yearly return potential. (Roughly 70% of fund assets reside in that share class.) That figure ultimately clocks in as average relative to other funds in its peer group, while the fund's A shares earn an above-average mark.

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