What the Pimco saga can teach advisers

Due diligence on funds requires blending performance data with professional judgment

Fund due diligence is both an art and a science. The science relies on rules for making decisions based on quantitative factors, such as investment performance. The art, on the other hand, involves qualitative judgments and is often what fiduciaries find most challenging.

The saga of leadership changes at the top of the Pimco fund group provides a case study of how qualitative factors can be the predominant basis for decision making when dramatic events occur. Waiting for quantitative evidence can be risky because it may only serve to confirm what the qualitative evidence already suggested. Making unnecessary changes can be costly, but failing to act may expose the portfolio to avoidable losses.

In January, Pacific Investment Management Co. announced that chief executive and co-chief investment officer, Mohamed El-Erian, was leaving the mutual fund giant. This followed reports of tension between Mr. El-Erian and Bill Gross, the famous “Bond King” fund manager and Pimco co-founder. At the time, some analysts questioned whether turmoil in the leadership ranks at Pimco might foretell future problems for the company.

Sure enough, on Sept. 26, Pimco announced the departure of Mr. Gross to join Janus Capital Group Inc. as manager of the Janus Global Unconstrained Bond Fund. At Pimco, Mr. Gross not only managed key funds, including the massive Total Return Fund, but he also led the investment committee that made critical economic and interest rate calls for the firm.

While the Total Return Fund had been under pressure from outflows for more than a year due to subpar performance, the moment Mr. Gross exited, outflows ballooned. And the damage was not limited to the Total Return Fund. The loss of the “Bond King” prompted redemptions throughout the fund group. In September alone, more than $25 billion was redeemed from Pimco funds, followed by nearly double that in October.

Given the facts of the situation, what should a prudent fiduciary to a portfolio holding Pimco funds do? The first response is to follow all applicable guidelines found in governing documents such as the investment policy statement. A common example would be a policy to exit any actively managed fund when the primary manager who is credited with the fund’s success ceases to be the manager. The track record and tenure of an active manager are critical due-diligence criteria. When a star manager departs, investors and fiduciaries have to consider their options as well.

WHAT ABOUT THE REST?

But what about other funds in a group that is experiencing organizational upheaval and may face broad-based redemption pressure? What should a fiduciary do to avoid the losses associated with acting too late?

To answer that question, qualitative factors should be considered at three levels: (1) the credibility of the organization’s response, (2) likely marketplace ramifications and (3) factors that are specific to the portfolio under the fiduciary’s care.

In the Pimco example, the organization responded decisively to the departures of both Mr. El-Erian and Mr. Gross. When Mr. El-Erian left, the company immediately named six deputy chief investment officers and established a succession plan to prepare for the possibility of future departures, including that of Mr. Gross. By the time Mr. Gross departed, Pimco had assembled key pieces to execute a transition plan.

Pimco’s enormous scale and prominence make marketplace considerations more important than would be the case with smaller, less influential fund groups. Pimco’s investors are predominantly institutional. The major risk is that institutions can collectively move massive amounts of money if a herd mentality to sell sets in. That doesn’t seem to have happened (yet) in this case. Moreover, sell decisions precipitate buy decisions. Sellers would need to find suitable alternatives that are ready to accept huge inflows of money efficiently and effectively.

Portfolio-specific considerations include costs, portfolio strategy and the availability of suitable alternatives. The availability of alternatives, in particular, can make change relatively easy and prudent. With few choices, change is likely to be problematic.

In performing due diligence, the process is paramount. Knowing what to assess, being vigilant in monitoring events and statistics, and documenting the logical connection between factors considered and decisions made serves to connect the science and the art of sound professional judgment.

Blaine F. Aikin is chief executive of fi360 Inc.