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Downgrading PIMCO Total Return to Bronze

We remain positive on the fund overall after the departure of Bill Gross, but some resulting outflow and management uncertainties bring our rating down.

As part of our ongoing assessment of Bill Gross’ departure from PIMCO, we’ve made this sample Global Fund Report available for readers as a sample of Morningstar Manager Research Services’ institutional research. For more information regarding Morningstar Manager Research Services, please contact Dan Lefkovitz.

Download a PDF version of this report here.

Analyst View

Entering a new era.

PIMCO Total Return enters a new era with uncertainty but also a good deal of promise.

Morningstar remains positive overall on PIMCO Total Return after the departure of Bill Gross but is downgrading the fund to Bronze because of the resulting uncertainty regarding outflows and the reshuffling of management responsibilities. When PIMCO co-founder Gross resigned on Sept. 26, 2014, the firm quickly selected Dan Ivascyn as its new "group chief investment officer," and announced that three PIMCO veterans--Mark Kiesel, Mihir Worah, and Scott Mather--would take over this fund, with Mather leading the effort. 

It will take some time to see how Ivascyn and the new managers will coalesce as a team in their new roles, but there are a number of reasons to believe they will be successful after the dust settles. For starters, this is an experienced and well-respected group, with both Kiesel and Ivascyn earning Morningstar Fixed-Income Fund Manager of the Year accolades in recent years. As sector specialists, they were often credited by Gross for feeding him their best bottom-up ideas. Meanwhile, changes to the Investment Committee also bode well. The addition of Kiesel and Ivascyn to the group earlier this year following Mohamed El-Erian's departure added important feedback from the firm’s best bottom-up investors, while the returning Fed maven Paul McCulley and veteran manager Chris Dialynas provide economic heft from the firm’s macro thinkers. The challenges posed by outflows from the fund remain a wild card, but a hefty 42% stake in a mix of U.S. Treasury bonds and agency mortgages, in addition to cash flows received from coupon payments and maturing securities, is grounds for cautious optimism that the fund should be able to withstand a significant storm. 

The fund’s Bronze Morningstar Analyst Rating reflects Morningstar’s high level of confidence in PIMCO’s resources and overall abilities but also the uncertainty as to exactly how all of these parts will mesh in the wake of Gross’ departure.

A stellar long-term record with periodic stumbles remains relevant to this fund’s new management. 

When managers leave, it often makes sense to discount a fund’s past performance. Indeed, Bill Gross’ public profile and the fact that he was the fund's founder and sole named manager gave the impression to many that he had single-handedly built the fund’s long-term record. However, Gross never denied having a tremendous amount of help. 

So it makes sense to give some attention to the fund's prior record, which has been a bit choppy since 2011. Gross had kept duration and government-bond exposures muted during that year, worrying that long-maturity Treasuries were too rich. But they began rallying in the second quarter, and the fund lost 1.1% in the third quarter, while its benchmark galloped to a 3.8% gain. It stumbled again in the summer of 2013, in part because of a spike in long-maturity yields that hit its Treasury Inflation-Protected Securities allocation especially hard and because of its exposure to sinking emerging-markets debt. And yet thanks in part to a strong 2012, those troubles have taken its five-year return only down to the second-best quartile in the intermediate-bond category, while its three-year and longer-term returns continue to rank among the category's best. The fund's new managers will not get all of their calls right, yet over the longer haul, PIMCO as a firm has gotten things more right than wrong. Even in Gross' stead, there's reason to believe that may continue to be the case. 

Hard to justify but still fair.

This fund has been a big revenue driver for PIMCO. Its advisory fee generated more than $641 million for the fiscal year through March 2014, and its supervisory and administrative fees pulled in $608 million. The fund has not featured management-fee breakpoints that would lower fees as assets grew, and some share classes--at this fund, the A shares and Institutional shares--are competitively priced, but others are relatively steep. As such, it’s important to be choosy when picking a share class here. The better-priced classes have a big advantage.

Proven skippers in their own right take on a new challenge. 

Bill Gross had been synonymous with this fund since its 1987 inception, so his Sept. 26, 2014, resignation was jarring. However, he left behind an enormous staff of talented managers and analysts that he had hired and trained over the years, and they have stepped up to take on important roles in his absence.

They include 2013 Morningstar Fixed-Income Fund Manager of the Year Dan Ivascyn-- PIMCO's new "group chief investment officer"--and several other PIMCO veterans concurrently promoted to oversee large areas of the market as CIOs of their respective sectors. Three of them, Mark Kiesel (2012 Morningstar Fixed-Income Fund Manager of the Year), Mihir Worah, and Scott Mather, have been tasked with managing this portfolio as a team. Mather will serve as lead manager with final decision-making power.

Overall, PIMCO's staff has tremendous depth--arguably more today than it did 18 months ago--boasting world-class practitioners and intellects across the board, even despite some high-level departures since 2008. The deep sector experience of Ivascyn and the new CIOs should be a big plus for the firm's Investment Committee. Meanwhile, that body will still benefit from the continued presence of macroeconomic experts such as Andrew Balls and Saumil Parikh, as well as PIMCO veterans Chris Dialynas (returning from sabbatical) and Paul McCulley, who rejoined the firm in mid-2014. 

Well-equipped to handle anticipated outflows, at least in the near term. 

Given Bill Gross’ abrupt departure, investors have focused on the possibility that outflows could wreak havoc on the portfolio. Snap estimates of expected outflows have been all over the map, but it seems likely that outflows could total in the tens of billions of dollars.

There's no sure-fire way to predict how the fund will fare if the worst of these fears are realized, but there are some good indications that it is well positioned to weather a pretty large storm. Although liquidity has been an area of recent focus for all PIMCO funds, the firm's macroeconomic outlook has also played a big role in tilting this fund toward more-liquid exposures. As of August 2014, for example, it had a 29% exposure to a combination of conventional Treasuries and government-agency debt, along with 13% in agency mortgages. Treasuries are extremely liquid, and the mortgage TBA forward contracts that likely comprise a good slice of the agency mortgage bucket also offer good liquidity. Meanwhile, PIMCO has for some time emphasized exposure to the short end of the maturity spectrum overall, and that meant a 49% weighting in bonds maturing in less than five years.

It's possible that outflows following Gross' departure could be much worse, but the period from the fund's May 2013 asset peak to September 2014 saw roughly $70 billion in outflows according to PIMCO, and there has been no indication that they caused any unusual problems. 

Main components of this fund’s strategy remain intact. 

Newly appointed managers Scott Mather, Mark Kiesel, and Mihir Worah don’t expect any big changes to the fund's strategy. The process will continue to be based on macroeconomic forecasting (supported by PIMCO’s Investment Committee) and bottom-up analysis to determine interest-rate, yield-curve, currency, country, sector, and security-level decisions. The managers plan to defer to each individual’s area of specialization when making security-specific decisions, with Mather ultimately making the final call.

Following the departure of co-CIO Mohamed El-Erian in January and now Bill Gross, the Investment Committee has undergone significant change. With the addition of some of the firm’s best fundamental analysts, including new group CIO Dan Ivascyn, the committee has shifted from being dominated by macro specialists to being more balanced with those focused on bottom-up analysis. Meanwhile, the return of firm veteran Paul McCulley in mid-2014 and the anticipated return of Chris Dialynas later this year helps provide macroeconomic heft following Gross’ departure.

Today’s Investment Committee is designed to do a better job of channeling the expertise of PIMCO’s many talented investors into a coherent and successful strategy. However, the fund’s success depends on how well this body and the firm’s new managers coalesce and work together.