SEC’s investigation into Pimco could ripple through ETF, fixed income markets

An SEC investigation into how Pimco, the world’s largest bond fund manager, valued some securities in its Total Return Bond ETF could spill over into the expanding universe of funds that invest in hard-to-value assets, according to industry watchers.
Bill Gross, who manages the largest bond mutual fund and the second largest actively managed exchange-traded fund, faced a new setback this week as the Wall Street Journal reported his Total Return Bond ETF has been under investigation by the Securities and Exchange Commission.
At issue is whether the fund company artificially boosted returns by relying on lofty valuations of mortgage-related investments it bought at a discount, the Journal said.
Some advisers said the report could signal more similar investigations.
“I’m surprised the SEC hasn’t opened more inquiries like this,” said Paul Schatz, president of Heritage Capital in Woodbridge, Conn. “Most investors don’t know that most bonds do not trade on an exchange, but rather in a dealer market. As such, price discovery can be all over the map.”
Some industry professionals think the underlying market makes it difficult for fund managers to trade bonds even as ETFs have surpassed them in terms of liquidity and proper valuation.
“As these funds have gotten more complex with thinly traded securities, it’s become even a bigger challenge,” said Terrance Gallagher, Milwaukee-based executive vice president at UMB Fund Services, a consultancy.
Questions over the subjective valuations used by fund companies to value small fixed income holdings have long been looked at by the SEC, but they have been increasingly on the agency’s radar this year. Their examinations of alternative mutual fund providers, for instance, have included a focus on the way firms value assets, according to two sources with knowledge of those efforts.
Indeed, Pimco and other fund companies sometimes rely on price quotes on its unsold securities furnished by third-party pricing services such as Interactive Data Corp., Thomson Reuters, Bloomberg L.P. and Markit Group, according to company disclosures and industry experts.
Those price quotes can be based on old market data, information from market-makers or estimates based on other similar securities.
“The scary thing is, I deal with a lot of firms that are a hell of a lot smaller that don’t have the infrastructure of a Pimco,” said Todd Cipperman, a Wayne, Pa.-based compliance lawyer. “When they see this, it chills people.”
Details on the SEC’s reported investigation of Pimco are scant and could not be independently verified. SEC spokeswoman Judith A. Burns declined to comment on Wednesday.
But the attention to Newport Beach, Calif.-based Pimco added a new blot to the reputation of Mr. Gross, the industry’s embattled totem.
Mr. Gross boasts one of the best track records in bond investing history, but his firm has suffered nearly $64 billion in withdrawals over the last year after the fund posted spotty performance and Mohamed A. El-Erian, a former heir apparent, announced his departure.
“Any time somebody at the SEC opens up an investigation, it’s rarely anything but bad news for your brand,” said Jeff Tjornehoj, head of Americas research for Denver-based Lipper.
“Pimco has been cooperating with the SEC in this non-public matter, and we take our regulatory obligations and responsibilities to our clients very seriously,” said Pimco spokesman Mark Porterfield, in a statement late Tuesday. “We believe our pricing procedures are entirely appropriate and in keeping with industry best-practices.”
The firm declined to comment further.
The impact on the bond market is unclear, but Pimco may feel the results sooner. In a note to clients, analysts at Citigroup Global Markets Inc., a New York-based investment bank, said the SEC investigation is likely to further tarnish Pimco’s brand.
“The probe highlights the increased regulatory environment [and] offers an opportunity for asset managers to take share from Pimco,” according to the note by analysts William R. Katz, Neil Stratton and Steven J. Fullerton. It said firms should expect delayed product reviews and rising regulatory costs.
Jeff Benjamin contributed reporting.