Life after Bill

Friday, September 26th 2014 will be etched into the memory of followers of investment management companies and fixed income investors alike. Shortly after lunchtime, when London based manager researchers and consultants were probably settling down to an afternoon of email inbox and desk tidying, Janus Capital announced the recruitment of William “Bill” H Gross. Indeed, many will have missed this given the high likelihood of an email from Janus being ignored or deleted (Janus has struggled to reinvent itself after riding the tech bubble up and down and then becoming embroiled in the 2003 market timing scandal).

Within minutes the newswires were alive with the news that PIMCO – Bill Gross’ home for the last 43 years – eventually confirmed in a statement which confirmed the general observation that relationships within PIMCOs Investment Committee and with the business heads had become increasingly challenging.

This is the “big one” which will have transition managers salivating. Investment manager moves are not uncommon; sometimes they run a few hundred million dollars, maybe a few billion. Occasionally, a manager is responsible for a few tens of billions of dollars. The size of the AUM under a managers’ control will typically determine the workload for the manager research and investment consulting community along with the number of words written by journalists. Bill Gross is best known as the manager of the US$220bn Total Return Bond Fund and was the named portfolio manager on 27 PIMCO Funds and ETFs according to their own press release. It is probable he was named manager on many more segregated accounts run for pension funds and other institutions. As CIO of PIMCO, and given Gross’ temperament, he will have had some level of influence on every one of the US$2 trillion dollars managed by PIMCO.

The very scale of these figures is overwhelming and they are all well reported in the press which means the ‘phone of every manager researcher or investment consultant with exposure to PIMCO will be ringing and the inbox will fill up faster than he or she can press delete. Anyone tasked with coming to a reasoned opinion on the strategies that were run by Bill Gross, other PIMCO strategies and indeed PIMCO as an investment house should turn the newswires off and the Do Not Disturb button on. It behoves these consultants to now think clearly and advise their clients about PIMCO ex Gross.

Bill Gross led the investment team of PIMCO.

There was a clearly articulated investment process built around regular meetings of the upper echelons of the investment team, a team which has been expanded significantly over recent years. Depending on which of the new CIOs you speak to, PIMCO has between 240 and 400 portfolio managers.

In their communications so far, PIMCO have noted that until Friday 26th September, the investment competency operated on a founder-led model.

In plain English, this means that Bill Gross determined investment policy and strategy.

This agrees with our understanding of Bill Gross’ level of influence across the firm, built from conversations with employees past and present. The highly structured investment process allowed the firm to run a huge book of business efficiently (PIMCOs operational protocols are top-notch). Going forward, PIMCO will operate a team based model. To this end, PIMCO now has a Group CIO; Dan Ivascyn and five additional CIOs; Andrew Balls, CIO Global; Mark Kiesel, CIO Global Credit; Virginie Maisonneuve, CIO Equities; Scott Mather, CIO US Core Strategies; and Mihir Worah, CIO Real Return and Asset Allocation.

What is the collective term for a group of Chief Investment Officers? A clutch? A huddle? For evidence of this move to a team approach, we can see that on all the high profile fund strategies, a single named portfolio manager (Gross or Scott Mather) has been replaced with a team of two or three portfolio managers. These managers are going to have to spend time with manager researchers to demonstrate clear lines of accountability within this approach. They must convince investors of their ability to adapt to a new operating model – notwithstanding any protestations that they are just “doing what they have always done”.

We were told on a conference call by PIMCO’s President that Bill Gross’ departure marked the “conclusion of a prolonged period of succession planning”. This indicates that the aforementioned CIOs and others have been positioning themselves over the last year to achieve their own personal ambitions. Hence, the new structure may well be the result of a series of horse trades. There will undoubtedly be disappointments which can lead to resentment, dysfunction and, ultimately, departures. A high level of organisational instability is a clear and present danger. Of course, the fact that Gross has turned his back on the team could unite the wider group in the same way as the presence of a management consultant can act as the focus of hostility in a dysfunctional organisation causing team members to put differences aside and work together towards a shared goal. Only time will tell and for now we have a high level of uncertainty around the organisational environment in which PIMCO’s investment team members operate.

At Cerno Capital, our preference is to be confident that the investment managers we entrust with capital are sitting in a stable environment which allows them to give their full attention to investment issues when they choose to do so.

Clients of PIMCO will look to the underlying exposure of their accounts as part of their analysis of the situation. A portfolio of US Treasuries has a very different complexion in comparison with an unconstrained bond fund or a total return bond fund – the favoured strategies of Bill Gross who has historically made significant use of credit, derivative overlays and securities, a concoction which is plainly not vanilla.

It is reasonable to expect some of the assets previously managed by Bill Gross to follow him to Janus; likewise it is reasonable to expect some clients to look for a manager with less organisational risk.

This inevitably leads to a consideration of liquidity as concern grows over a destabilising event in the markets. PIMCO have so far told us that “the bond market is big”, “people forget how liquid the bond markets are” and “cash and treasury holdings are high as a result of our new neutral hypothesis”.

It is true that bond markets are big; it is also true that PIMCO is big and it is true that size does not in itself infer liquidity. Some people may have forgotten what the over-riding level of liquidity is in bond markets, but most investment managers we talk to remind us regularly that liquidity in credit markets is exceptionally poor given changes in market structure since the financial crisis. Cash and treasury holdings may be high relative to PIMCO’s recent history, but the Total Return Bond Fund exposures to MBS, credit and emerging market debt remain significant at 41 percent of total market value according to PIMCOs last summary. In specie transfers, particularly in PIMCO’s book of segregated accounts would reduce any short term market impact, however, it is reasonable to expect some turnover and leveraged investors are likely to try to get ahead of any PIMCO position unwind.

Some might view it as fitting if events resulting from Bill Gross’ departure mark a significant juncture in the history of fixed income markets.

At the risk of sounding like a broken record, the organisational risk presented by significant outflow surely outweighs any short term market impact for an existing or potential client of Gross’ former shop. PIMCO have told us that they have hired significant numbers of people in recent years. PIMCOs revenues are tied to their asset base. If assets shrink, revenues shrink and the cost base (staff numbers) may have to shrink to retain profitability. A shrinking firm is rarely a happy firm.

Then, there is a potential impact on investment performance if outflows are sizeable and prolonged. Redemptions are funded by cash and payments will therefore lift the percentage of a fund exposed to less liquid assets. If selling pressure is maintained in the less liquid parts of the portfolio, the performance impact is magnified as the portfolio moves further away from the portfolio manager’s targeted allocations. Furthermore, there is the danger of a negative psychological impact from a continual stream of redemptions that can result in portfolio managers simply throwing in the towel – typically at the point of maximum pain.

The allocator or manager researcher tasked with delivering an opinion on a PIMCO strategy or on the firm must assess the above risks and place probabilities on the outcomes. To do so will require an intimate knowledge of the processes in place at PIMCO and of the relevant individuals and their relationships within the broader firm. With a firm the size of PIMCO, this knowledge can only be accumulated over many years of working with PIMCO.

PIMCO’s clearly presented investment approach, its well-resourced investment team and highly efficient operational structure has enabled it to run large blocks of capital in both tightly defined and more unconstrained investment mandates. The efficiencies of scale result in an ability to offer active portfolio management at relatively low cost. This has allowed PIMCO to become the fixed income manager of choice on many consultant buy-lists and gather large numbers of segregated accounts from institutions and addition to institutional subscriptions to its pooled vehicles.

The investment team at Cerno maintains an approved list of manager strategies from which we construct portfolios, a key difference when compared to a consultant buy list is that we do not require multiple options in each asset sub-class, in order to cope with the multi-billion dollar accounts which follow consultant recommendations. This naturally steers us away from asset gatherers and towards firms where investment performance is the number one priority. Furthermore, access to key decision makers is a core tenet of our approach and while this is easily obtainable by look to investment boutiques, we are also able to navigate the corridors of some larger operations where we can locate like-minded investment professionals who can clearly articulate an approach which we believe will make money and crucially, who have a clear thought process around the capacity of their strategy.

Cerno Capital client portfolios have no exposure to any PIMCO funds.

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About the Author:

Fergus surveys the full range of the firm’s investments on a bottom up basis and is principally engaged in manager and security selection. He began his investment career at Valu-Trac Investment Management in 1995, where he worked in their global equity and asset allocation products. He worked for Russell Investments as a Portfolio Manager of UK equities (2001-2006) and Asian equities (2006-2009). Fergus graduated from Edinburgh University with a BCom (Hons), holds the CFA charter and is a member of the CFA Society of the UK. Fergus is a Director of the Salters’ Management Company.