Gross Takes On His Rivals

Most investment junkies know that one of the best places to find nuggets of insight--and the occasional blast of digressive humor--is the periodic column of bond-fund legend Bill Gross, which appears on PIMCO's Web site. Gross is often iconoclastic, disagreeing with captains of industry and conventional wisdom on economic trends, interest rates, and just about anything else. What's uncanny, though, is that when it comes to his prognostications, Gross turns out to be right in an astounding number of cases. He has assailed the corporate-bond market for a couple of years now as overvalued and too risky, and as the investment-grade corporate bond market has imploded in 2002, his flagship charge, PIMCO Total Return (PTTAX), has managed to trounce most competitors. His frequent shorter-term calls on the direction of interest rates have arguably been even more noteworthy in that they've helped keep Total Return (and other funds under his tutelage) near the very top of their peer groups for years and years.

For all of his insight and prescience, though, Gross may be overreaching a bit in the August version of his Investment Outlook. In it, he says, "One of the largest bond 'index' funds in the world has for many years run its portfolio with a corporate 'tilt'--substituting short-term corporates in the Pollyannaish belief that bankruptcies don't occur overnight, they're 'just out there somewhere' like an X-files alien or something. … Similarly, other large bond shops, which along with PIMCO are known as the 'Big Seven,' cast their fate … with corporate bonds because they yielded more. How brilliant did you have to be with a corporate overweight anyway? Hire some credit analysts, pretend you know more than the clients from whom you're charging (sic) 50 basis points and take it all the way to the bank, baby. Life is sweet with a few billion under management, 50 basis points and a corporate 'tilt.' … A few of these 'Big Seven' have tilted all right, but tilted as in a pinball game--meaning, 'Game Over.' That's what 2 percent positions in Enron and WorldCom will do for you." Gross continues, "PIMCO of course does not wear virgin white. …We also make mistakes--witness our premature entry into energy and telecom bonds in order to cyclically increase our corporate debt exposure."

Gross rightly chastises those who would blithely overweight corporate bonds simply to earn their higher yields. But by skewering prominent rivals for the practice, he raises some questions about his own firm's practices and bond-picking.

For one thing, Gross ignores the fact that many of his "Big Seven" peers--which would seem to include Blackrock, Western Asset, and Metropolitan West--aren't yield-chasers at all. Rather, they pursue strategies similar to, and in some cases, modeled on Gross' own "total return" ethos. Like Gross, Blackrock et al look down upon less-enlightened competitors who still covet the highest income payouts because high yields help sell funds. Instead, just like Gross himself, all of Gross' true peers have shown a willingness to dump sectors with high yields if they're worried about their prospects, or they see better values elsewhere.

And though Vanguard Total Bond Market Index (VBMFX) (he doesn't mention its name, but is there another "index fund" he could possibly mean?) doesn't engage in sector rotation, to suggest its manager is a yield-chaser with skimpy research is laughable. The notion of using short-term investment-grade corporates to enhance returns is a method PIMCO itself uses in its short-term portfolio, and Vanguard has a larger credit staff and a more reputable manager running Total Bond Market Index than most active funds could ever wish for. The bottom line is that Gross is characterizing a lot of his competitors as yield mongers, but that's simply not the case.

It's Gross' suggestion that some of his competitors aren't doing their homework that is most intriguing, though. It's true that PIMCO Total Return was underweighted in corporate bonds, and it didn't have 2% positions in Enron and WorldCom. It didown both of those credits, though, something that wasn't the case for all his rivals. Moreover, Gross' fund has also been the less-than-proud owner of some forgettable names such as Qwest , Tyco , AT&T Canada (ATTC), MCI, Sprint , Williams (WMB), America West, United (UAL), US Air  … well, you get the idea. Yes, Gross' funds are on top this year, but that's because his other bets have been bigger and have paid off sufficiently to overwhelm his mistakes. Nonetheless, the mere presence of so many disastrous credits in Gross' portfolios (severe laggards AOL  and AT&T (T) were also in the top-20 holdings of Fremont Bond , which suffered a bit more damage as a result) indicates that he wasn't able to steer clear of the same issues that he ridicules his peers for failing to avoid because of their shoddy credit research.

Are we trying to discredit Bill Gross? Absolutely not. We didn't name him Morningstar Fixed-Income Manager of the Year twice without good reason. We're in a highly unusual period in the corporate-bond world, though. And though the depth of the damage has varied greatly, almost none of the best bond-fund managers have been spared the indignity of owning what have proven to be horrendous credits. To chalk up the suffering to lazy and incompetent management is too simple--and in many cases, inaccurate.

When the best in the business, including Gross himself, are caught up in the storm, the problems start to look a lot wider and more indicative of enormous structural tumult, rather than some sudden exposure of managerial incompetence. Sure, Gross foresaw the weakening of the corporate market more accurately than just about anyone else; he obviously didn't know that legions of investment-grade household names were going to drop like stones, though. The fact that his rivals didn't either doesn't make them bad managers, just human ones, like Mr. Gross himself.