Bill Gross, who runs the world's biggest mutual fund, takes a seat in a conference room and makes a confession. Overlooking the ocean at the headquarters of Pacific Investment Management Co., Gross describes missteps that doomed his bond firm's experiment with equities in the mid-1980s.
At meetings where Pimco set its strategies, Gross's bond traders overwhelmed the firm's handful of equity managers, shooting down their bullish arguments promoting stocks. With limited freedom to pursue their own investing ideas, the equity managers quit after about two years.
“Those sessions basically said, ‘Hey, we're a bond shop. This is what we're going to do. It's the party line,'” Gross, 66, says. “If I've been a problem, then I can be the solution in terms of allowing equity investments to grow and prosper.”
Pimco, which has been synonymous with bonds for almost four decades, is taking another run at equities. It may not be the most propitious time to plunge into stocks. Volatility, as measured by the Chicago Board Options Exchange Volatility Index, was at a 14-month high in late May, as the sovereign debt crisis swept through Europe.
Driving Pimco's move into equities is CEO Mohamed El-Erian, who says the global economy is entering a period of fundamental transformation he calls the “new normal.”
"Remarkable Time of Change'
El-Erian says mounting deficits and tighter financial regulation will dampen growth in the U.S. and the euro zone for the next three to five years. Emerging-market nations such as Brazil and China, with stable levels of government debt and expanding middle classes, should continue to thrive, he says.
In the new normal, investors will be faced with anemic returns and they'll seek alternatives, says El-Erian, who's embracing several new asset classes. In the past year, he's presided over the creation of an equity mutual fund and a unit to invest in hedge, real estate and buyout funds. Pimco has also started 10 exchange-traded funds.
“We are living through a remarkable time of change,” says El-Erian, 51, who shares the title of chief investment officer with Gross. “We want to make sure we navigate the changes for our clients.”
Not everyone agrees with this analysis from Newport Beach, California-based Pimco. Some U.S. cabinet officials and securities analysts say El-Erian's new normal is off the mark.
More than 2,000 forecasters set price estimates showing the Standard & Poor's 500 Index will jump 26 percent in the 12 months through May 2011 as corporate profits rise, according to data compiled by Bloomberg.
Some investors say the firm might be better off sticking to what it knows best. Gross's flagship Pimco Total Return Fund, using a complex concoction of bonds, futures and credit-default swaps, has outperformed 97 percent of its fixed-income rivals during the past decade.
“When a fund company expands into new business lines, I get very nervous,” says Martin Weil, whose Healdsburg, California- based MW Investment Strategy Group Inc. manages $30 million, much of it in Pimco funds. “I have a very high degree of respect for Pimco. Am I going to dive into their equity offerings? No, but I'll take a look.”
The three-decade rally in bonds, the very securities that made Gross famous, will eventually fizzle out, according to Pimco's outlook. Gross says the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.
Bonds Best Days Behind
“Bonds have seen their best days,” says Gross, who anticipates returns of 4 percent to 5 percent in the new normal.
The king of bonds is now talking up stocks as a better long-term investment. He says that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and, eventually, real estate.
“If you're talking about the next 10, 15, 20 years, there's certainly the recognition that assets will grow faster in those categories,” he says. “Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period.”
Gross's prophecy on bonds may not be coming true anytime soon. Since May, when he warned that European nations like Greece can't rely on growth to finance their soaring deficits and would likely default, investors have poured into U.S. Treasuries.
While Pimco estimates that U.S. debt has the potential to soar to 90 percent of gross domestic product, the country remains a haven for investors. Even Gross increased his Total Return Fund's holdings of government-related debt, which includes U.S. Treasuries, in May to the highest level since November. The yield on the 10-year Treasury note fell to 3.12 percent as of 5 p.m. yesterday.
Spearheading Pimco's push into equities is EqS Pathfinder, a global fund the firm launched in April that buys undervalued securities, mainly in Europe. Its only U.S.-based holding in the top 10 positions is SPDR Gold Trust, an ETF that buys gold. Most of Pathfinder's major positions -- British American Tobacco Plc, French foodmaker Groupe Danone SA and Hong Kong-based Link Real Estate Investment Trust -- derive at least part of their earnings from emerging markets.
Pathfinder, which had attracted more than $500 million, declined 1.7 percent in the month ended on June 7, beating 96 percent of similarly managed funds, according to Bloomberg data.
Some analysts say Pimco's exceptional performance with bonds gives it an advantage with all investments. In Europe, widening bond spreads last year were a warning sign for equity investors of the looming debt crisis, which sent European stocks to an eight-month low on May 25, says Cynthia Steer, chief research strategist at Darien, Connecticut-based Rogerscasey.
“It's a needed look at equities through the bond view,” says Steer, whose firm oversees $265 billion in assets for institutional investors, many of whom have money with Pimco. “Their research on sovereign debt is excellent, bar none.”
With $1.1 trillion in assets, Pimco is expanding into stocks as part of an effort to lure more individuals to its funds. They're the fastest-growing group of investors, accounting for 84 percent of all U.S. mutual fund assets at the end of 2009, according to data from the Investment Company Institute in Washington.
Individuals also pay more than institutions. The Total Return Fund charges retail customers annual expenses starting at more than 1 percent of assets compared with less than half of that for institutional and 401(k) investors.
Pimco's income helped fuel the robust results in the first quarter at the asset management unit of its parent, Munich-based insurer Allianz SE. The unit's operating profit jumped 121 percent to 466 million euros ($555.6 million) from a year earlier -- a figure that helps explain Allianz's hands-off approach to Pimco.
As Pimco increases its use of ETFs, it lags behind BlackRock Inc., the world's biggest fund manager, with $3.36 trillion in assets. New York-based BlackRock last year bought Barclays Global Investors mainly to get iShares, the No. 1 manager of ETFs, with $509 billion in assets.
Pimco controls only about $1 billion in its ETFs, with three actively managed bond funds and seven others that track indexes linked to U.S. Treasuries.
The two men responsible for plotting Pimco's strategy share adjoining desks. Their personalities couldn't be more different. El-Erian deliberates over almost every decision, while Gross often acts out of instinct. At a round wooden table in a 10- foot-by-10-foot conference room that served as Pimco's first bond-trading floor, El-Erian, the son of an Egyptian diplomat, says he's a worrier by nature. When he was 10 years old, his mother, who's French and Egyptian, urged him not to take life so seriously.
“She said to me, ‘If you don't have something to worry about, you create something to worry about,'” says El-Erian, who runs day-to-day operations at the firm of 1,300 employees. He worked over the details of starting stock funds for some two years.
Gross, who directly manages 24 mutual funds, relies on his gut, as well as endless reams of data.
“He is much bolder,” El-Erian says. “He has this amazing instinct. I've never seen anything like it.”
Cone Of Silence
The two leaders rarely speak to one another on the floor. Gross enforces a policy of near silence, sometimes by glaring at offenders who talk too loudly.
“I think Mohamed is respectful of my, sort of, isolation,” says Gross, sitting in the conference room with his blue-and-red printed tied unknotted. “You wouldn't find me walking around giving high-fives.”
El-Erian, on the other hand, frequently touts the new normal on financial news shows. His fairly bleak long-term outlook has drawn its share of criticism. In an April speech at Princeton University, Christina Romer, head of the White House Council of Economic Advisers, said she found the fatalism of the new normal distressing. Romer said that shorter-term cyclical events like the drop in demand were the real drag on job creation.
“Unemployment is high fundamentally because the economy is producing dramatically below its capacity,” Romer said. “That is, far from being the new normal, it is the old cyclical.”
El-Erian's biggest challenge may be internal. As the CEO builds a stable of new funds, he'll have to overcome the embedded bias for bonds that took root in 1971 with the founding of the company. When Gross and his two bond-trading partners left Pacific Mutual Life Insurance Co. to set up their own firm across the street, they decided against taking an equities manager with them.
“It would have been better to bring the equity person,” Gross says. “We would have been balanced from the beginning.”
Decades later, the then-parent company of Pimco took a stab at stocks that ended in a legal scandal. In 1999, Pimco Advisors Holdings LP started Pimco Equity Advisors. The stock unit was separate from Gross's bond shop and didn't provide any financial benefits. Yet the equity group hoped to get a boost from the success of Gross's business by taking the Pimco name.
The equity managers got off to a fast start, almost doubling assets to $9.6 billion by 2000 before running into legal trouble. In civil complaints, the Securities and Exchange Commission and New Jersey's attorney general accused the equity unit in 2004 of allowing a hedge fund to engage in market timing, a practice of making short-term trades to exploit market inefficiencies.
Following the lawsuits, Gross said that he regretted allowing the group to use the Pimco brand. The equity unit, which didn't admit or deny wrongdoing, paid a combined $68 million in fines and repayments to investors to settle the lawsuits. Allianz dissolved the stock group after the settlements. Allianz spokesman Eduard Stipic declined to comment on the lawsuits beyond previous statements.
This time, Pimco will control the equity funds and integrate them into the firm. In keeping with Pimco's bearish view on America, the firm doesn't plan to create funds with a focus on U.S. blue chips.
“We're not going to launch a large-cap U.S. fund,” says Neel Kashkari, the former TARP official who now heads Pimco's move into new asset classes.
The $227.9 billion Total Return Fund became the world's biggest mutual fund in 2009, as Gross lured in investors with his handling of the financial crisis. Gross saw the mortgage debacle coming and was able to dodge most of the damage -- thanks partly to one of his passions, yoga.
In 2005, he suspected a housing bubble had formed. During a yoga session, it occurred to him to send analysts posing as homebuyers into the field to test his theory. The research helped him decide as early as 2005 to avoid subprime-mortgage-backed securities.
While Gross shunned subprime debt, he hasn't shied away from other complex investments in his Total Return Fund. Morningstar analyst Eric Jacobson says the manager boosts returns partly by using derivatives.
Gross increased his holdings of CDSs in 2009 as the sovereign-debt crisis began to shake Europe. The fund sold insurance on credit from countries such as Italy and the U.K. and almost doubled its CDSs on sovereign debt to about $1.4 billion on Dec. 31 compared with three months earlier, according to Pimco's February filing with the SEC. The manager boosted his bet in the first quarter, selling default protection covering almost $5 billion in sovereign debt on countries such as Brazil, France, Panama and the U.K.
Drip, Drip, Drip
Gross also buys forward contracts or futures on Eurodollars, Treasuries and other investments, typically putting down a 5 percent to 6 percent margin deposit, according to Pimco filings. He then deploys the money that he saved by not buying the actual investments in short-term cash equivalents such as commercial paper, Jacobson says. The fund owns no bonds from Greece, Portugal or Spain.
Lawrence Weinman, an independent financial adviser who manages about $20 million in Los Angeles, steers his clients away from Gross's handiwork. “You don't know what's in it,” says Weinman, who worked at Morgan Stanley and Societe Generale SA. “Putting money in with Bill Gross and saying, ‘Just put it anywhere you want,' is not the way I advise people to invest money.”
Certainly, Pimco won't become a powerhouse in equities anytime soon. The company has hired only about 12 executives, managers and analysts to work in stocks, ETFs and funds of funds, with plans to add several more.
“In terms of the drip, drip approach of doing this slow, I can't say it's going to be successful,” Jacobson says. “But they want to make sure everybody they bring in is not only Pimco caliber, but also Pimco style in their thinking.”
El-Erian says he's expanding cautiously to avoid damaging the main bond business upon which Pimco is built. “We are very careful not to dilute what has served our clients well,” he says. “And that comes from being very realistic about what you can deliver.”
You Say You Want an Evolution
Anne Gudefin and Charles Lahr, the value-oriented managers who run Pimco EqS Pathfinder, aren't in a hurry to buy stocks. In December, El-Erian hired the duo, who had managed Franklin Templeton Investment's Mutual Global Discovery Fund. Their Pathfinder fund held about 22 percent of its assets in cash as of the end of April.
Following the 10 percent plunge in the MSCI World Index in April and May, the managers may deploy more money. “We're happy to say that the current sell-off is highlighting some interesting opportunities,” the managers said in an e-mail.
Thirty-nine years after he founded Pimco, BIll Gross, the king of bonds, says the firm's new funds are a sign of his own evolution.
“It simply means perhaps we've grown up. And I have.”