How PIMCO Fund Ratings Are Shaking Out

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. It's been a little bit over a month since Bill Gross unexpectedly left PIMCO. I'm joined today by Russ Kinnel, he is the head of our analyst rating committee, and also Michael Herbst, he is our director of manager research for active strategies in North America, to get an update on our view of PIMCO and how we've changed the ratings on several funds.

Gentlemen, thanks for joining me.

Russ Kinnel: Good to be here.

Glaser: So, could we talk a little bit about what manager research has been doing over the last month in terms of assessing changes at different PIMCO funds and how your thinking has evolved there?

Kinnel: So, we're looking at all the personnel changes because Bill Gross' departure set off a whole round of changes at a number of funds. We're looking at flows. We're looking at any tweaks to strategy and trying to understand, within each team, how well equipped they are to handle the changes and, in some cases, added responsibility. So, we've been [sifting] through, debating all this, rating funds, and by now we have rerated all of PIMCO's funds.

Glaser: Let's look at the market reaction, then, before we get to the changes to our ratings. In terms of flows, I know we've got some preliminary data; but taking a look at it, how much money has left PIMCO and have you seen it accelerating or do you think the worst is behind them?

Michael Herbst: I think the easiest data point that most people are looking toward as an indicator of firmwide activity at this point are flows out of PIMCO Total Return (PTTRX), the firm's flagship strategy. In October, we saw about $32.3 billion in outflows from that fund. If you combine that with outflows in September, the fund has lost about $50.1 billion in assets over the past two months. That sounds staggering, but the data would suggest that those outflows really haven't had any marked impact on the fund's performance.

That is not altogether surprising in our conversations with Bill Gross over the past year and more extensive conversations with a number of people including the fund's three new managers over the past month or past six weeks. The portfolio had ample liquidity coming into this and by any number of angles, including if you look at daily performance in October or the fund's performance overall during the period of October, its performance for that trailing month lands right at the intermediate-term bond category's midpoint. It actually outpaced its average peer. It lagged the [Barclays U.S. Aggregate Bond Index] by a slight margin as did three quarters of its peers. The main thing that we can determine at this point is that the fund's slightly shorter duration was probably the biggest contributor to that performance over that trailing month.

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Glaser: Closed-end funds were another area people were maybe looking at to get a sense of how the market was reacting. Have there been any big changes to the premiums or discounts to the PIMCO closed-end fund family?

Herbst: We did see some pretty pronounced decreases in the premiums for the five closed-end funds that Bill Gross had managed. Yet, they all rebounded close to or even above historical levels within a couple weeks after his departure. So, by late October, the funds were trading as they had been prior to his departure, and that's another reflection that some investors have chosen to stick with those funds, given the depth and the breadth of PIMCO's research operation backing them.

Glaser: Sounds like the market's concerns have been waning somewhat. During your conversations with some of the new management team or with some of the people who have been elevated to new roles, do you get a sense yet of how these teams are working together? Are you really starting to see the teams gelling or is it too early to tell?

Kinnel: I think it's pretty early days to say very definitely, but I think things are positive in trend. I think what's particularly encouraging is that we're seeing people come back. When Bill Gross left initially, some people wondered would this be like the case where Jeffrey Gundlach who left TCW to form DoubleLine and a bunch of people followed him across the street to DoubleLine. So far, in fact, it's going the other way. PIMCO is having outflows of funds, but it's having inflows of people. So, I think that's encouraging. In terms of how they gel, I think it's pretty early and that's obviously one of our concerns is that you still have very good, smart people; but obviously, they have some dynamics to sort out to really get back to humming smoothly.

Glaser: So, big changes to the investment committee. Obviously, the funds that Gross managed personally, there are lots of changes there. In terms of downgrades, what funds or what sections of the firm do you think are going to be the biggest or have you seen the biggest impacts?

Kinnel: I think among them I would say something like the Foreign Bond Group, with Scott Mather taking on added responsibilities, is one area where we lowered the ratings a bit because we saw some shifts in the dynamics there. Obviously, the funds Bill Gross ran directly are the ones most impacted, but I would say those were among the groups that were impacted as well.

Herbst: Two other areas, too: PIMCO Unconstrained Bond (PUBAX) is a strategy that's seen a couple of manager changes over the past year. That's one where we just want to see everything kind of settle back into place, given the flexibility that that strategy has. We also downgraded Mihir Worah's funds not because we have less confidence in the team, per se, but this is a case where Mihir Worah's responsibilities have expanded a great deal over the past year, both in the wake of Mohamed El-Erian's departure in early 2014 and even more so now in Gross' departure. I'd say one mitigating factor there is Jeremie Banet, one of his lieutenants who had left the team in mid-2014, has returned to the fold, too. So, that's also encouraging.

There are a couple of areas where we're going to be watching to see how PIMCO chooses to continue to build out resources, perhaps around Mark Kiesel, perhaps around Mihir Worah, perhaps around the fundamental-equities effort led by Virginie Maisonneuve. These are some of the areas where we're going to be looking for additional resources over the next year or two.

Glaser: Were there any upgrades or any areas you think were less impacted by the move?

Kinnel: We actually upgraded PIMCO Muni Bond. The muni group was pretty largely unaffected, though obviously the investment community does have some input on macro calls. But there, Joe Deane has passed his three-year mark at the firm and built up the staff. So, it's just a matter of feeling a little more confident in the process. It isn't really related. It's not that we're saying Bill Gross' exit is a positive for the fund; it's just that it doesn't have a big impact. The EqS funds, as Michael mentioned, [which are PIMCO's equity funds], are now run by Virginie Maisonneuve, and we think they're not very impacted. Our ratings didn't change. They were already Neutral. So, it wasn't like they were great before, but we don't think those are very impacted either.

Glaser: Let's take a look at all of PIMCO, then: If we're having some of these downgrades, if they are seeing some outflows, are you worried that PIMCO has a chance of becoming weaker, that they're not going to be able to invest, given the smaller asset base? Is that something that concerns you?

Herbst: Not today. And there are a couple of reasons for that. One reason is that PIMCO runs a very lean operation. So, their cost structure is actually more attractive than many other asset-management firms. The flip side of that coin is that they are actually more profitable than many asset-management firms. That's important for a couple of reasons. One, their compensation is well above the industry averages, which is going to make it difficult or more costly for other people to poach headcount, if that's what other firms are looking to do.

A second thing to keep in mind is that its corporate parent, Allianz, has been very supportive--not only of PIMCO as a firm but of group CIO Dan Ivascyn and other folks taking on key responsibilities. Why this is really important is because Allianz has also signed off on PIMCO's retention packages, its compensation packages, and its additional hiring packages. Something that hasn't gotten a lot of press lately is the fact that PIMCO continues to hire. It's added more than 20 managing directors to its portfolio-management team this year alone.

We've done a fair amount of modeling around how the bonus pool works and how a shrinking asset base could affect the firm's economics, if you will. And without going too far into the weeds, our analysis at this point would suggest that PIMCO could sustain outflows of up to $300 billion to $350 billion in an orderly way over the next two years without necessarily getting into trouble with operating margins with Allianz or with its shrinking bonus pool.

Kinnel: I would add, too, that the other encouraging thing is the total value of money that went out in October is huge, but the trend shows that it really spiked in early October and has come down significantly to a much more sustainable level of flows. Now, obviously, if say, performance were to be poor the next year, maybe I think those outflows will at least continue at the current pace, but I think it's encouraging that a lot of the people who were going to get out got out in those first two weeks, and so it now looks like a more manageable process from here.

Herbst: I think one other thing that we're keeping an eye on, too, and this can be a tougher thing to handicap, but there is some other less data-driven evidence that would suggest that PIMCO might actually be a more stable operation in some ways than prior to Gross' departure. We've had, at this point, close to three dozen conversations with some of the key players of PIMCO over the past six weeks, and it's our impression that group CIO Dan Ivascyn is actually fostering a more collaborative, more open working environment. By no means has the firm lost its competitive edge. If anything, that edge is actually probably a little bit more intense than it was a month or two ago.

But what's key here is that Dan Ivascyn seems to recognize the value of opening up the lines of communication across a broader swath of the firm than previously [was the case]--which, to me, if I'm working in fixed income and I like to work in a high-performing culture, being able to participate in a more active way is actually a huge benefit in terms of the direction of the firm at this point, too.

Seeing how that shakes out is one of the key areas that we're going to watch for. Obviously, the investment committee at PIMCO has a huge influence on the positioning for funds across the lineup. Our initial thoughts at this point are that, despite slight changes in the composition of the committee, the level of expertise and the depth of expertise has not necessarily been harmed with Bill Gross' departure, which is encouraging.

Glaser: Overall, then, it sounds like the downgrades show that maybe you're a little bit more cautious on some of the funds in the short term, but you think that, long term, the future for PIMCO could still be pretty strong?

Herbst: At this point, yes. Obviously, there are a lot of things to still keep a close eye on, and we will continue to. We will certainly monitor the situation in terms of flows and personnel and performance as it unfolds. Our views may change, if the facts change. But at this point, we actually feel very comfortable with where PIMCO is at today.

Kinnel: So, I think the departure of Bill Gross is a short-term negative. There are more things in flux, more stuff to sort out. But longer term, there's an opportunity for them to be on a more stable path. Bill Gross was already past standard retirement age. So, in a sense, you could see this coming. It's just that, obviously, the speed was shocking and jarring in a lot of ways. A smoother transition might have been the ideal thing. But even so, if people stick around at PIMCO, they could be a pretty good shop a year from now. We just want to see how things look as the dust settles.

Glaser: Russ, Michael, thanks for the update.

Kinnel: Thank you.

Herbst: You're welcome.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.