PIMCO in Better Shape Than Expected

Morningstar recently issued a new Stewardship Grade for PIMCO. The firm's overall grade--which considers corporate culture, fund board quality, fund manager incentives, fees, and regulatory history--is a C. What follows is Morningstar's analysis of the firm's corporate culture. This text, as well as analytical text on the other four Stewardship Grade criteria, is available to subscribers of Morningstar's software for advisors and institutions: Morningstar Advisor Workstation(SM), Morningstar Office(SM), and Morningstar Direct(SM).

PIMCO's corporate culture is on much more solid ground than one might expect given the tumultuous 2014 departures of former co-CIOs Mohamed El-Erian and William Gross. The firm's leadership team--helmed by CEO Doug Hodge, president Jay Jacobs, and group CIO Dan Ivascyn--has done an admirable job navigating what has been the most challenging stretch in the firm's history. Yet given still-considerable areas of uncertainty, PIMCO's Corporate Culture score remains a C.

Following Gross' departure, PIMCO moved quickly to implement a $279 million retention package aimed at its senior-most investment personnel, and since then, the firm has seen only a small handful of senior-level departures, including central-bank watcher Paul McCulley and generalist Saumil Parikh. There is further evidence that suggests PIMCO's corporate culture may actually be healthier now than it had been under Gross. For one thing, a number of investment personnel have returned to the fold, including Marc Seidner (who serves as CIO of nontraditional strategies, and in May 2015, re-assumed oversight of the firm's fundamental equity strategies), real-return specialist Jeremie Banet, longtime generalist Chris Dialynas (who returned from sabbatical shortly after Gross left), global generalist Sudi Mariappa (who returned in early 2014 before Gross left), economic advisor and Nobel laureate Michael Spence, and municipal-bond manager David Hammer. It's notable that PIMCO has hired 11 new portfolio managers and a number of economic advisors since October 2015.

Ivascyn has also been explicit in his intention to foster a more collaborative team-based culture, evidenced in the team structure implemented at flagship

PIMCO remains one of the strongest, deepest, best-resourced teams in fixed income, with more than 250 portfolio managers with an average of 20 years' experience (nine years at PIMCO) as of March 2015. At that point, the firm had close to 800 investment professionals overall, averaging 14 years' experience (six at PIMCO).

Yet the firm faces a number of challenges going forward. First, outflows have been on the higher end of what PIMCO, its corporate parent Allianz, and Morningstar had anticipated. Between June 2014 and March 2015, the firm's overall assets under management fell roughly 19%, to $1.59 trillion from $1.97 trillion. During that stretch, $111.8 billion in outflows from the U.S.-domiciled open-end version of PIMCO Total Return accounted for roughly 30% of that decline, with the remaining shrinkage stemming from other Total Return vehicles and a handful of other strategies, including

Arguably, PIMCO went into those outflows in a relatively strong financial position. It had a cost structure well below the average for asset managers, partly because of its scale and efficiencies gained from its 2000 decision to outsource its entire back-office operation to State Street. At the point of Gross' departure, compensation for the firm's top investment personnel topped virtually all of its rivals--providing a strong incentive for them to stay with the firm--and the portfolios for most of the funds that have experienced the heaviest outflows were highly liquid. As of May 2015, most funds' absolute and relative performance had not been markedly affected by the outflows, and the teams backing them have remained stable overall.

Although firmwide outflows have been trending down in 2015, they've put pressure on the firm, potentially weighing on morale and fueling a rising cost structure and lower profitability that may become a concern to Allianz. While Allianz has expressed patience, and Morningstar believes PIMCO's autonomous relationship with Allianz remains stable as of June 2015, sustained outflows or acceleration of those outflows could begin to affect the firm's 2015 year-end compensation pool; impact its ability to retain and attract top-caliber personnel; or ultimately test Allianz's patience--especially in light of that firm's November 2014 decision to increase its dividend.

As of June 2015, Morningstar believes a spike in outflows going forward is unlikely. But they're still a possibility if absolute or relative performance for large and high-profile PIMCO strategies does not remain strong past the September 2015 one-year mark of Gross' departure. At that point, advisors, institutional investors, and gatekeepers, including defined-contribution plan managers or consultants who placed PIMCO "on watch" following Gross' departure, may be tempted to cut bait if performance is disappointing. As of May 2015, outflows have been subsiding, and relative performance across many of PIMCO's strategies remains solid. But PIMCO will not be out of the woods financially or from a corporate-culture standpoint until the outflows eventually turn to inflows in the form of returning or new business.

Where that future growth will come from is an open question if investors continue to reallocate out of PIMCO fixed-income funds or fixed income in general. PIMCO's first attempt to build out its fundamental equity business faltered, with multiple missteps under its former head Neel Kashkari (who left in January 2013) and more recently under his successor Maisonneuve, who was named CIO of global equities in January 2014. In May 2015, PIMCO announced Maisonneuve's departure and the liquidation of three fundamental equity funds. Although those funds accounted for less than 0.1% of the firm's overall assets under management, the liquidations signal a shift in the future direction of PIMCO's $50 billion equity business.

Two fundamental equity teams remain in place, the dividend-oriented team under Brad Kinkelaar and the global long-short effort under Geoffrey Johnson. But in a shift away from fundamental, actively managed equity strategies, PIMCO is likely to focus its future efforts on existing and new strategies related to the strategic-beta approaches of Research Affiliates under Rob Arnott, and others related to its "PLUS"-named portable alpha strategies (

Sundstrom's arrival is significant for several reasons. First, while not formally named as a manager, she is playing a key role at

More broadly, Morningstar is also watching the overall evolution of PIMCO's investment culture. Despite a more collegial tone under Ivascyn, PIMCO's hard-charging, competitive ethos has definitely remained intact--that's a positive in terms of attracting high-performers, but also a contributor to the firm's historically persistent level of personnel turnover, particularly in the ranks just below the CIOs and other long-tenured lead portfolio managers. Thus far, PIMCO has bucked the odds and has continued to attract a steady stream of high-caliber personnel. But the stakes remain high for continuing to do so going forward, when considering the expertise and experience of those who have left the firm in recent years, including Gross, El-Erian, and McCulley during the past 18 months, Scott Simon in 2013, Bill Powers in 2010, Mark Hudoff in 2009, Pasi Hamalainen and John Brynjolfsson in 2008, Zhu Changhong and Ray Kennedy in 2007, and so on.

There are a few other areas to watch in the background. Historically, PIMCO hasn't been particularly fund-shareholder-friendly in its approach to fund expenses. While its institutional share classes are generally reasonably priced, expenses on some of its noninstitutional share classes had remained stubbornly high. The firm has made some progress on that front via expense waivers, and many of its D shares appear more reasonably priced when considering investors in comparable shares may be paying transaction fees not reflected in other funds' expense ratios. Even so, historically PIMCO hasn't passed on the benefits of economies of scale of large funds to fund investors via fee breakpoints, as other firms have.

The firm has also been very prolific in its new fund launches. Most have been driven by ideas and developments in institutional management or, in some cases, developments in financial markets that have made one strategy or another newly feasible. Yet some, like PIMCO's forays into target-date funds and the actively managed fundamental equity strategies that are being liquidated, have struggled to find a wide investor base. And while Ivascyn has voiced greater openness to the idea of closing funds, PIMCO doesn't have a historical record of doing so. How those trends evolve under its new leadership bears watching.

To reiterate, the firm's current leadership is off to an encouraging start, and its CIOs represent a reassuring level of continuity amid 2014's turbulence. PIMCO continues to attain or approach best-in-class status across many of its investment capabilities, while its more collaborative approach, new Investment Committee structure, and evolving secular/cyclical forum process are still works in progress. So is the manager structure on PIMCO Total Return, where lead manager Mather works closely with comanagers Kiesel and Worah. PIMCO's steps to providing additional support for those managers--via Sundstrom, Banet, and commodities experts Nic Johnson and Greg Sharenow for Worah, and via credit specialists Mohit Mittal and Jon Horne for Kiesel--are positive signs, as is investment in the forum process and other support structures, including Mattu's quantitative analytics team. But it's still relatively early days for the post-Gross PIMCO, and given the uncertainty remaining around flows and their potential ripple effects, as well as the firm's future growth trajectory, it's difficult to say the firm has definitively turned the corner. Thus, despite laudable efforts from PIMCO and encouraging signs its corporate culture could actually be healthier than it was under Gross, its Corporate Culture grade remains a C.

This article is the Corporate Culture portion of the Morningstar Stewardship Grade for Principal Funds. See Morningstar's Stewardship Grade methodology on our corporate website.