Pimco’s second act: Alternatives?

Bill Gross may be publicly mourning the end of the bond market’s long run, but don’t weep for Pacific Investment Management Co. LLC just yet.

The firm synonymous with fixed income has positioned itself quietly to become an alternative investment powerhouse. So if Mr. Gross’ dire predictions are right, his company is poised to reap the benefits as financial advisers look for alternatives to bonds.

In an interview this year, Mr. Gross, founder and co-chief investment officer of Pimco, predicted that bonds were headed for annual returns of 2% to 3% over the next few years — struggling to keep up with even modest inflation.

That prediction proved to be almost too optimistic in the first quarter, as the Barclays U.S. Aggregate Bond Index notched its first negative quarter in seven years.

The sluggish returns, coupled with jitters over the potential of an increase in interest rates, already have started to show in sales of the firm’s flagship total return strategy.

The Pimco Total Return Fund (PTTAX), which Mr. Gross manages, averaged $1 billion of net inflows during the first three months of this year, down 33% from its monthly average last year, according to Morningstar Inc.

You would never know it by looking at Pimco’s overall inflow numbers, though.

Thanks to its alternative products such as the $34 billion Pimco All Asset Fund (PASAX), the $24 billion Pimco Unconstrained Bond Fund (PUBAX) and the $2.5 billion Pimco Worldwide Fundamental Advantage Absolute Return Strategy Fund (PWWAX), Pimco has actually been doing better this year than in 2012.

The firm averaged $7.7 billion a month of net inflows through the first three months of the year, second only to The Vanguard Group Inc. and up from $5.2 billion a month last year, according to Morningstar.

Even though Pimco has had success with its fixed-income alternatives — assets in its alternatives funds total $110 billion, up from $28 billion in 2008 — it hasn’t captured the segment the same way it has bonds.

The title of alternatives king is still “completely up for grabs,” said Nadia Papagiannis, an alternatives analyst at Morningstar.

The good news for Pimco, advisers said, is that the trend toward fixed-income alternatives isn’t likely to be short-term, so the firm has time to cement its place.

“We are rethinking fixed in-come,” said Jeffrey Layman, chief investment officer at BKD Wealth Advisors LLC. “The first stage was investing in satellite bond holdings like high-yield and emerging- markets debt, but those have been so bid up, they look like they will earn their coupons, at best.”

That has forced Mr. Layman to start looking at more alternatives, something that Jacob Wolkowitz, an investment manager at Accredited Investors Inc., agrees can help lower the risk of the fixed-income side of a portfolio, while maintaining bondlike low volatility.

“We think we can generate pretty consistent, not spectacular, returns that won’t be adversely affected with interest rates [by using alternatives],” he said.

Brian Ullsperger, managing director at WTAS LLC, started looking at fixed-income alternatives recently as the stock market rallied to new highs and it came time to re-balance client portfolios.

“Right now, it’s a little hard to re-balance directly into fixed income,” he said.

Pimco has been able to capitalize on the fixed-income-alternatives trend by focusing on what it does best, mainly bonds and currency, Ms. Papagiannis said.

“They’ve dipped their toe in,” she said. “They’re not launching strategies they don’t have expertise in and they’re not launching strategies they don’t have the back-office support for.”

The Pimco Unconstrained Bond Fund, for example, is run by the same management team as Pimco Total Return.

The difference is that the latter bases its investment decisions on its benchmark index, while the former starts with a “blank sheet of paper,” said Sabrina Callin, managing director and head of liquid alternatives at Pimco.

The Unconstrained Bond Fund also has the ability to short the bond market, while the Total Return Fund is limited to an average weighted duration plus or minus two years of the Barclays U.S. Aggregate Bond Index.

“It’s more active,” Ms. Callin said. “Every exposure is specifically chosen.”

TRACK RECORDS

Pimco also has benefited from launching its products ahead of the competition and having track records. The All Asset Fund, an absolute-return fund, has been up and running since 2003, while the Unconstrained Bond Fund was launched in 2008.

When the Unconstrained Bond Fund started, there were only 18 nontraditional bond funds.

Today there are 52, according to Morningstar.

“We know Pimco has expertise from what they’ve done in the past,” said Mr. Layman, who uses the Pimco All Asset Fund.

Pimco could run into a problem if it branches out into alternatives in which it doesn’t have a lot of expertise, Ms. Papagiannis said.

“They need to incorporate or buy a shop that has a philosophy that doesn’t conflict with Pimco’s,” she said.

When Pimco decided to delve into long/short equities last year, the firm did just that, Ms. Papagiannis said.

“They found a manager with a super-duper track record and purchased it,” she said.

Another long-term concern about Pimco’s liquid-alternatives business is its size. Given that most alternatives strategies have size constraints, it is too early to tell whether some of the strategies will work at Pimco’s level.

For example, Geoffrey Johnson, portfolio manager of the $305 million Pimco Eqs Long/Short Fund (PMHAX), was running his strategy at less than $20 million when it was acquired by Pimco.

Ms. Papagiannis said that it is best to take a wait-and-see attitude to gauge whether the fund can keep up its performance at larger asset levels.

“Pimco measures things in billions, not millions,” she said.

Mr. Johnson’s strategy has worked so far this year. It was the top-ranked long/short equity fund through April 18, according to Morningstar. Its 13.3% return was more than 900 basis points better than the category average.

The size concerns aren’t confined to the equity space. Mr. Wolkowitz has stayed away from investing in the All Asset Fund because of its size, as well.

“The enormity of the fund is a concern,” he said.

But Mr. Layman likes the size of the All Asset Fund.

“We need liquid alts that can be implemented consistently across all of our clients’ portfolios,” he said.