Understanding Investments Insight. Education. Analysis. April 2014

Due Diligence Report Management Changes at PIMCO By Kevin Chambers

One of the most intriguing and widespread financial news stories in the past year has been the sudden departure of PIMCO CEO and co-Chief Investment Officer (CIO), Mohamed El-Erian. Pacific Company, commonly referred to as PIMCO, is one of largest investment management firms in the world. This U.S.-based firm operates as an autonomous subsidiary of , the German giant, and manages almost $2 trillion in assets. Although PIMCO invests in many different asset classes across their various products, they are predominately known for their expertise including the management of the largest bond mutual Photo Credit: Reuters/Lori Shepler 2012 fund in the world. Let’s look at some questions concerning the current situation at PIMCO and lay out some of the reasons we at Headwater Investments believe PIMCO products are solid investments despite Within 10 years of its founding, PIMCO’s assets under the concerns. management (AUM) were over $1 billion, making the firm a major player. PIMCO continued to grow, The History of PIMCO reaching $100 billion AUM in the late 1990s, growing their ranks to 500 employees, and opening offices in PIMCO was founded in 1971 by Bill Gross, Jim Muzzy, Singapore, London, Sydney, and Tokyo. In 2000, PIMCO and Bill Podlich. They started with $12 million under sold controlling interest in the company for $3.3 billion management. PIMCO has always been a little different to Allianz, but has continued to operate independently. than the traditional elite financial firms. First is the location of their headquarters. While most leading One of the founders of the firm, Bill Gross (age 69) is investment managers are based out of the financial considered to be the most influential bond investor in centers of New York, Boston or Chicago, PIMCO’s the United States and is often referred to as the “Bond home office is in Newport Beach, California, next door King.” Born in Ohio, Gross attended Duke University, to the famous Fashion Island shopping mall and just off where he studied Psychology. After he received his the Pacific Coast Highway. Many traders on Wall degree in 1966, he moved to Las Vegas and played Street referred to them only as “The Beach.” Their blackjack 16 hours a day, counting cards. He joined the asset management style also set them apart from Navy and served as an officer on a destroyer in the traditional Wall Street firms. They were one of the first South China Sea during the Vietnam War. After shops to add value to fixed income portfolios by returning home, he attended UCLA and acquired his actively trading bonds. MBA. Out of school, he started working for Pacific

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Mutual Life, the company from which PIMCO originated. Gross is the portfolio manager on many of PIMCO’s biggest funds, including PIMCO Total Return (PTTRX), the largest bond fund in the world.

In 2008, Mohamed El-Erian (age 55) was named CEO and co-CIO of PIMCO. El-Erian was born in New York when his father was serving in the UN as an Egyptian diplomat. He spent most of his childhood in Egypt before his father became the ambassador to France. He received his undergraduate degree in economics from Queens’ College, in Cambridge, England, and received a doctorate in economics at Oxford. El-Erian started his career working for the International Monetary Fund in Washington, DC. He then became a managing director for Citigroup in London before taking a job at PIMCO in 1999 as a senior member of the firm’s portfolio management and investment strategy group focusing mostly on emerging markets. In 2005, El-Erian left PIMCO for two years to run Harvard University’s $32 billion endowment. In 2008, he rejoined PIMCO as CEO and co-CIO with Bill Gross. El-Erian was tasked with overseeing corporate and investment strategy. El-Erian quickly became the new public face of PIMCO, and Gross was quoted as saying, “Mohamed is my heir apparent”(Fabrikant 2012). El-Erian also managed some of the firm’s global investment funds including the PIMCO Global Multi-Asset Fund (PGAIX). Photo Credit: http://www.etftrends.com/2012/07/ pimco-total-return-paves-the-way-for-more-active-etfs/ Problems Arise

In January 2014, El-Erian suddenly announced his resignation from the firm. The announcement stunned many people in the investment world because it was assumed that El-Erian would eventually take over for Gross. After the announcement, it became clear that the relationship between Gross and El-Erian was the primary reason for the departure.

In June 2013, the two men had an argument in front of a dozen or so PIMCO employees. The Wall Street Journal reported the argument peaked with Gross challenging El-Erian: "I have a 41-year track record of investing excellence, what do you have?" El-Erian responded with "I'm tired of cleaning up your s—," referring to Gross’s harsh management style and conduct with co-workers (Zuckerman and Grind 2014). Since the announcement, PIMCO employees have mentioned the difference in the two leaders’ backgrounds: Gross cut his teeth in the investment world; El-Erian came from academia. It seems Gross’s management style and the culture he has created at PIMCO was the driving force behind El-Erian’s resignation.

Conceivably poor performance in 2013 did not help the situation. PIMCO’s headline fund, Total Return, managed by Gross, returned -1.9% and investors pulled over $41 billion. El-Erian’s Global Multi Asset Fund (PGAIX) performed very poorly, returning -8.4% in 2013. There was also tension surrounding El-Erian’s push to diversify PIMCO’s products out from bonds.

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The work culture at PIMCO is intense. Employees are expected to be at their desks by 4:30am and usually stay past 5:00pm. Thus, 60- to 80-hour work weeks are not uncommon. The trading floor, usually a hectic, loud environment, is kept completely silent at Gross’s request. Former employees have mentioned that Gross has a problem with dissenting views and that he has a tight fist on his traders, not allowing them leeway to make decisions. A UCLA management professor was hired as a consultant by the firm and reported after three years of observation: "You had a lot Photo Credit: http://www.theatlantic.com/magazine/ print/2011/06/the-vigilante/308503/ of very talented people who were, in effect, nervous about their positions. It was an unhealthy atmosphere for PIMCO in the long run, and they needed to address the issues" (Zuckerman and Grind 2014). El-Erian knew about this environment, from his previous work experience, and fought with Gross to change it. His attempts to try and rein him in led Gross to allegedly declare during a meeting with traders, “if only Mohamed would let me, I could run all the $2 trillion myself…I'm Secretariat. Why would you bet on anyone other than Secretariat?”(Zuckerman and Grind 2014).

Despite all of this, Gross’s often dictatorial management style has been successful, and has earned him a lot of respect in financial circles. He was the first person to win Morningstar’s Fixed Income Manager of the Year three times (1998, 2000, and 2007). He also won Fixed Income Manger of the decade for 2000-2010. He was the first portfolio manager to be inducted into the Fixed Income Analysts Society’s Hall of Fame, and was named the most influential authority on the by his peers in a survey by Pensions and Investments magazine (PIMCO Experts 2014). Apart from growing PIMCO into a market powerhouse, his returns have been very good. His flagship fund, Total Return, has a 5-year annualized return of 7.2%, a 10-year return of 5.9%, and a 15-year return of 6.6%, which outperforms the Barclays U.S. Aggregate Bond Index by more than 1% for each respective time period.

Outlook

Headwater Investments is concerned about PIMCO and the affect of the corporate culture and leadership on their investment management. We plan to monitor them very closely. Since the news broke about El-Erian’s departure, we have had conference calls and emailed with representatives at PIMCO. In mid-April 2014, Scott and Tom visited the PIMCO headquarters in Newport, California. They met with Amita Sheth, who is a Vice President at PIMCO and is the contact person for Headwater Investments in Newport. Sheth is in constant contact with portfolio managers, upper management, and product managers at PIMCO. Scott and Tom were given a tour of the trading floor and their experience confirms many of the stories surrounding Bill Gross and PIMCO. The trading floor, with about eighty staff members, was completely silent. When Scott about the silence, the answer was, “Bill likes it because it limits mistakes.” Most of the communication is through email or, if traders or managers need to talk, they have designated conference rooms. Scott and Tom saw Bill Gross working in his office, but did not meet with him.

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They did, however, meet with one of the superstars at PIMCO: Daniel Ivascyn (44). Ivascyn is the co-manager of the PIMCO Income Fund (PIMIX), a fund that many Headwater Investment clients are invested in, which beat 97% of its peers in 2013 and returned 4.8% in a year when the bond market lost 2%. Over the past 3 to 5 years, PIMIX beats 99% of peers. He won the 2013 Fixed Income Manager of the year with his co-manager Alfred T. Murata. The consensus among the financial press is Ivascyn is the new heir apparent to the PIMCO kingdom.

Scott and Tom also met with two product managers to talk about Headwater Investments allocation to foreign fixed income. According to Scott and Tom, both PIMCO representatives were knowledgeable, listened to their concerns, and answered all of their questions thoroughly. However, they both agree that even though PIMCO is trying to get out from under the management of “one man,” they still have a long ways to go. It seems that what Bill says is what Bill gets. Most of the questions that were asked to PIMCO were answered with “Bill wants…” or “Bill thinks….”

While Bill Gross may be a difficult man to replace, there are some promising individuals still at the firm. The new CEO, replacing El-Erian, is Douglas Hodge. (left photo) Hodge went to Dartmouth and . He has 28 years of investment experience, 25 years of which he has been at PIMCO. Most recently, he has been managing the Asia-Pacific regional offices in Hong Kong, Singapore, Sydney, and Tokyo, and worked as PIMCO’s chief operating officer from 2009- 2014.

In the term, PIMCO has changed their executive management structure, splitting up investment and corporate management. Gross and El-Erian both held the title of co-CIO, with El-Erian also acting as CEO, a problem for Gross who is not good at sharing responsibility for investment decisions. Now Gross is sole CIO, with Hodge as a separate CEO. This will allow Hodge to focus on firm management while allowing Gross to be responsible for investment decisions.

Gross also has 6 deputy CIOs, including Ivascyn (left photo) and Andrew Balls, (right photo) another rising star who runs PIMCO’s European funds out of London. Each of the deputy CIOs has specialties in global bonds, corporate bonds, real estate, or equities. Gross is giving up partial control to his deputies within their specializations, giving them direct oversight of their trading desks. This allows the deputies to have more flexibility and discretion, with Gross acting in more of a supervisory role. As Ivascyn told Tom and Scott, the management structure is less of “one man” and more of a group of people, in which PIMCO feels will be better for the future.

At Headwater Investments, we see this as a move in the right direction. Gross is giving up some control of investment decisions, allowing the firm to operate without everything flowing through him. It also gives multiple people management experience, so PIMCO can cultivate Gross’ successor. We choose to invest in PIMCO because they offer good products that fit into our investment strategy, not because of their upper management.

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Headwater Investments does due diligence on about 15 different PIMCO products. We mostly use PIMCO products for specialized investments that have very few competitors. The two funds we use are PIMCO All Asset (PAAIX) and PIMCO Foreign Bond Unhedged (PFUIX).

• All Asset is a fund focusing on beating inflation. The investment decisions are managed by a different firm, Research Affiliates, run by a successful academic and investor named Rob Arnott, who uses quantitative methods to find investments that will do well if inflation rises.

• PFUIX is one of the only unhedged foreign bond funds on the market. Unhedged strategies allow investors to take advantage of fluctuations in foreign currencies as well as bond prices. PFUIX is managed by one of the new deputy CIOs: Scott Mather, a European securities expert.

We will keep a close eye on PIMCO funds to make sure they are doing what they are supposed to. We will make investment decisions based on our analysis of the fund’s performance, risk, and objectives. For example, in 2012 we began purchasing the PIMCO Global Multi-Asset Fund (PGIAX) that was managed by El-Erian. We had high hopes given El-Erian’s success with the Harvard Endowment. The mandate of the fund is to produce competitive long-term returns and limit downside risk. It has failed to meet this objective. At the end of the third quarter of 2013, we decided to liquidate all of our client assets from PGIAX. This was before any of the press came out about the issues between Gross and El-Erian.

We will continue to monitor all of the PIMCO products using the same metrics with which we monitor all of our investments. If any of the PIMCO funds fail to meet our expectations, we have alternative products for those investments. At the moment we do not see the resignation of El-Erian as a reason to pull our investments at PIMCO. The new management structure and the excellent team around Bill Gross are promising; however, we are watching the situation closely.

Works Cited

Fabrikant, Geraldine. "The Bond Market Discovers a New Leading Man." The New York Times , July 28, 2012.

PIMCO Experts. 2014. http://www.pimco.com/EN/experts/pages/billgross.aspx.

Zuckerman, Gregory, and Kirsten Grind. "Inside the Showdown Atop PIMCO, the World's Biggest Bond Firm." The Wall Street Journal , February 24, 2014.

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