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Fund Spy: Morningstar Medalist Edition

Weighing In on PIMCO Funds

Several changes and key things to watch going forward.

Morningstar has reassessed its view on PIMCO and PIMCO funds in light of several events surrounding Mohamed El-Erian's recent departure from the firm. On March 18, 2014, Morningstar lowered its Stewardship Grade on PIMCO to C from B. We also lowered the Parent pillar score of our Morningstar Analyst Rating for Funds on PIMCO funds to Neutral from Positive. PIMCO's overall personnel changes contributed to that change. But so did several other factors, including lower portfolio manager investment alongside fund shareholders, relatively high fees on many of PIMCO funds' noninstitutional share classes, and fund boards that could do more to stand up for PIMCO fund shareholders.

That chain of events triggered a reassessment of Morningstar Analyst Ratings on the firm's funds, as would any material firm-level change at the asset managers we cover. A downgrade in a firm's Parent pillar or Stewardship Grade does not mechanically or automatically force a downgrade in its funds' Analyst Ratings. That's because the Parent pillar is one of five contributing to a fund's Analyst Rating, alongside People, Process, Performance, and Price. In PIMCO's case, several portfolio manager departures and changes and a greater degree of uncertainty around its multiasset and equity strategies fueled several Analyst Ratings changes. We reaffirmed a number of Analyst Ratings as well, generally in cases where those funds' management teams were less affected by the ripple effects of El-Erian's departure.

Below we highlight the PIMCO fund Analyst Ratings that changed. We also detail the areas we're watching for evidence that the recent changes at PIMCO are working out or not.

A Few Downgrades
We have changed our Analyst Ratings on several PIMCO funds after assessing the impact of portfolio manager changes that occurred concurrent with or shortly after  PIMCO announced El-Erian's departure. The exhibit below summarizes those changes.  

We have, for example, lowered our Analyst Rating on  PIMCO Unconstrained Bond (PFIUX) to Neutral from Bronze. Prior to the announcement of El-Erian's departure, PIMCO announced in November that lead manager Chris Dialynas would be taking a sabbatical and that Bill Gross would be taking over the fund. Dialynas postponed his sabbatical's start date until April 2014 in light of El-Erian's departure, but Gross is well equipped to take over his lead-manager duties. It's not entirely clear how much change to expect along with Gross' leadership, but he has signaled he's likely to be a bit more intrepid than Dialynas was. That's notable because while the fund's performance has been less volatile than its largest competitors, it has produced correspondingly modest relative returns: That understandable risk/reward trade-off puts the fund in a tough spot given that PIMCO has often suggested that it should produce returns competitive with those of its Total Return strategy.

Like most category rivals, PIMCO Unconstrained Bond has been marketed partly on the premise of providing generous absolute returns while taking on less exposure to interest-rate risk than portfolios tied to commonly used benchmarks, such as the Barclays US Aggregate Bond Index. While the fund has taken on less credit risk than many nontraditional rivals in those pursuits--and has thus been less correlated with junky debt and equity markets--it has also been more highly correlated to the Barclays Aggregate and high-quality, more rate-sensitive bonds. So while there's a reasonable case to be made that the fund's more modest overall performance is a fair trade-off for taking less credit risk, it's more difficult to champion the fund as a competitive nontraditional alternative to core funds when it has displayed comparatively high correlations to those funds' key risk factors while still producing weaker returns.

We have also lowered our Analyst Rating on  PIMCO EqS Pathfinder  to Neutral from Bronze. PIMCO announced skipper Chuck Lahr's departure amid the El-Erian hubbub. Lahr and comanager Anne Gudefin plied their cautious approach successfully at world-stock offerings  Mutual Quest (TEQIX) and  Mutual Global Discovery (TEDIX) prior to joining PIMCO and launching this fund in 2010. Given the duo's cautious approach, it's not entirely surprising that the fund's performance has been mediocre versus its category rivals. Yet Lahr's departure leaves a hole in the team's research resources, particularly in the financials sector. In addition, new equity CIO Virginie Maisonneuve has also indicated plans to hire a new comanager and experienced financials analyst to support Gudefin; it will take time to see how that plays out.

It's also fair to say that PIMCO's equity effort is still nascent. Maisonneuve has indicated plans to expand the firm's equity fund lineup. For investors in PIMCO's corporate parent  Allianz  or big institutional investors who may be concerned that PIMCO's business may be overly reliant on its fixed-income operation, that may be a desired outcome. Yet the firm's struggles to do so thus far suggest that building out its equity fund lineup may be more difficult and energy-intensive than it may have anticipated. There's no guarantee that the lauded teams it has hired in recent years to run funds including PIMCO EqS Emerging Markets , PIMCO EqS Dividend , and  PIMCO EqS Long/Short  will be able to replicate their prior successes within PIMCO's pressure-cooker culture, especially if additional managers decide to leave. Also, if the funds including Gudefin's don't attract or retain assets, it's likely Maisonneuve and the equity-fund managers will come under even more pressure.

An Upgrade and Several Reaffirmations
On the other hand, we have raised our Analyst Rating on  PIMCO CommoditiesPLUS Strategy (PCLIX) to Silver from Bronze. The fund is managed within PIMCO's real return team, led by Mihir Worah, who was recently named a deputy CIO and permanent member of the firm's Investment Committee. He has quietly built out PIMCO's offerings in the real-return arena, with great success at funds that have included the Gold-rated  PIMCO Real Return (PRRIX) and  PIMCO Commodity Real Return Strategy (PCRIX) and the newer, Silver-rated  PIMCO Inflation Response Multi-Asset (PIRMX). Worah has also expanded his team, hiring specialists in energy and agriculture, and leaning more heavily on this fund's manager, Nicholas Johnson. That depth and the team's successful execution of this fund's strategy since its 2010 inception led to the fund's upgrade.

We have also reaffirmed our Analyst Ratings on PIMCO funds in cases for which we believe their management teams and strategies remain commensurate with our ratings. For instance, we reaffirmed our Gold rating on  PIMCO Total Return (PTTRX) on March 19, 2014. We are taking a close look at two funds where emerging-markets manager Ramin Toloui has been removed as a named manager, given the April 11, 2014, announcement that President Barack Obama intends to nominate Toloui for a Treasury Department post. Our understanding is that Michael Gomez has been and will continue to be integrally involved in the day-to-day management of the Gold-rated  PIMCO Emerging Markets Bond (PEBIX), while Andrew Balls will continue to head up the Bronze-rated  PIMCO Global Advantage Strategy Bond (PSAIX). Those skippers' continuing involvement and the depth of their teams lessens the potential disruption of Toloui's departure.

It's important to reiterate that reaffirming any one of our Analyst Ratings requires as much legwork by our analysts and ratings committees as actually changing a rating requires. In our reassessment of the 54 Analyst Ratings we've assigned to PIMCO funds in North America, our reassessment required analysts to propose and defend their ratings with our ratings committees on a fund-by-fund basis. All of our Analyst Ratings are considered "live" in that they reflect our current view on a fund--if the facts change at any fund, including these that we've just updated, we will reassess our views.

Where To From Here
It wouldn't be surprising if we were to see additional ripple effects from El-Erian's departure. Although it's difficult to predict exactly what those effects could be, we are keeping a close eye on several areas, including any future personnel changes. Future departures of key managers would trigger reassessments of individual funds or groups of funds. Should that trickle of departures increase, we'd look to identify whether recurring themes were driving managers' departures and whether those departures were truly detrimental to the firm's research depth. Departures of any of the sector heads or new deputy CIOs (Worah, Mark Kiesel, Dan Ivascyn, Maisonneuve, Scott Mather, and Balls), for example, would be red flags.

We'll also be assessing the impact of new arrivals. No matter how strong the pedigree of a new PIMCO hire or a new PIMCO portfolio manager, there's no guarantee they'll be successful. For instance, we wouldn't be surprised to see a senior-level external hire at  PIMCO Global Multi-Asset (PGAIX), which struggled under El-Erian, then under Saumil Parikh, then again under El-Erian. Worah is now in that fund's lead manager chair, but despite his success within narrower slices of the market, it's an open question as to whether he can execute a global asset-allocation strategy in addition to his new deputy CIO duties. An external hire could also signal additional changes to the fund's strategy or team. On a related note, we'll be watching for the new arrival(s) at EqS Pathfinder and potentially for a senior-level addition to Gomez's emerging-markets debt team.  

Hustle and Flows
Outflows from PIMCO Total Return have garnered plenty of media attention lately. In the table below we highlight PIMCO funds that have experienced the heaviest outflows and inflows over the trailing one-year period through March 31, 2014, as a percentage of their beginning period assets.


The data above suggests that outflows from PIMCO Total Return, while huge in dollar terms, haven't been as staggering in percentage terms. They also don't appear to have been debilitating to the fund thus far, but it is difficult to assess the impact of significant outflows from some portfolios. In the near term, sharp outflows can crimp a manager's style or force him to sell securities prematurely to meet redemptions. Those risks are greater for concentrated portfolios, especially in less-liquid sectors of the market such as high-yield debt. Arguably, those risks are less worrisome in less concentrated portfolios; those in very liquid parts of the market such as developed-markets government bonds; and those receiving cash flows from coupon payments and/or security amortizations. PIMCO Total Return is a behemoth, but it is quite diversified and checks off those two other boxes, with roughly 30% of assets in U.S. Treasuries, 15% in agency mortgages, 10% in non-U.S. developed markets, and an additional slice of assets in cash as of March 31, 2014.

More troubling is the shrinking asset base of PIMCO Global Multi-Asset and heavy outflows from  PIMCO High Yield (PHIYX). Outflows at PIMCO EqS Pathfinder have picked up in recent months and also bear watching. We're also keeping an eye on funds used heavily by  PIMCO All Asset (PAAIX) and  PIMCO All Asset All Authority (PAUIX). As our colleague Kevin McDevitt has written, those two funds are the biggest investors in more than a few underlying PIMCO funds. For instance, the All Asset funds' combined position in  PIMCO High Yield Spectrum (PHSIX) and  PIMCO Emerging Markets Currency (PLMIX) as of Dec. 31, 2013, accounted for more than 79% of those funds' assets. Because of the All Asset funds' heft, even a 1-percentage-point reduction in their positions in those two underlying funds could result in outflows of roughly 15%-20% of the underlying funds' assets.

The exhibit below displays the 10 underlying PIMCO funds rated by Morningstar analysts where the All Asset funds' positions as of Dec. 31, 2013, comprised a big portion of the underlying funds' assets:

Our understanding is that the portfolio managers of the underlying funds have the ultimate say on the timing of those redemptions, but such outflows may still be detrimental if poor market liquidity or the size or timing of the redemptions effectively handcuffs those managers. It also potentially limits their ability to take advantage of market opportunities. It's unfortunate that PIMCO hasn't taken more steps to segregate the funds used extensively by its funds of funds in order to protect the underlying funds' shareholders. A number of firms have taken such steps: Fidelity,  T. Rowe Price (TROW), and Vanguard have created funds used exclusively by their target-date funds, and Grantham, Mayo & Van Otterloo has long limited the use of some of its funds to its own funds of funds.

Over the longer haul, sustained outflows across the PIMCO funds complex could make it more difficult for the firm to attract or retain topnotch personnel.

PIMCO's Parent and Bill Gross' Succession Plan
On April 4, 2014, Reuters published an article suggesting that top shareholders in PIMCO's parent Allianz were beginning to amplify concerns about the direction and oversight of PIMCO's leadership, performance issues, executive compensation, and the firm's overall business mix. Although it's not known which shareholders are becoming agitated, that group includes a few of PIMCO's fiercest rivals, including  BlackRock (BLK) and Vanguard.

Thus far, Allianz has maintained an arm's-length relationship with PIMCO, which we've viewed positively. Our understanding is that PIMCO's governance system gives its managing directors plenty of say over the appointment and election of key officers, including Gross. In addition, it is safe to say that Gross remains invaluable to PIMCO's stability as an asset manager and, thus, a big part of PIMCO's value to Allianz. Clearly Allianz has a tough balance to strike between its shareholders and PIMCO, and we'll be watching for evidence that it is getting more involved in PIMCO's day-to-day affairs.

On a related note, we'll keep tabs on the evolution of the succession plan for Gross. Our interpretation is that the personnel changes that transpired in the wake of El-Erian's departure--particularly the appointment of the deputy CIOs and the naming of Doug Hodge as CEO and Jay Jacobs as president--are initial steps of a succession plan for Gross. Our current working assumption is that the plan will evolve over the next three to five years, that potential successors could emerge from the deputy CIOs or other senior members of the Investment Committee, and that PIMCO will not announce that plan until it is ready to implement. On that count, the firm learned the hard way by nudging El-Erian into that successor role, only to see him depart.

Appendix 1
Morningstar's Pieces on PIMCO Leadership Changes

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Michael Herbst has a position in the following securities mentioned above: PTTRX. Find out about Morningstar’s editorial policies.