Morningstar's bond-fund research team has downgraded PIMCO Total Return from an Analyst Rating of Gold to a lower but still-positive rating of Bronze following the departure of PIMCO founder Bill Gross.
About Time
This change was nigh-on inevitable. Successful founding investors tend to be dictatorial, obsessive and stubborn. (Demonstrating all three qualities, Dick Strong insisted when his company's headquarters was built that all screws be installed with their grooves vertically aligned, so that the screws would not gather dust.) Successful corporate managers, not so much. At $2 trillion in assets, PIMCO was long overdue for a management overhaul.
The company's structure was not only inappropriate for its size but also was bucking the spirit of the age. Time was when businesses run by founder/owners captured many—and sometimes most—new fund sales. The asset winners are the giant manufacturers, churning out cheap index funds and institutional actively-run funds that are high on risk controls and low on surprises.
The move would have occurred years ago had PIMCO's performance not been so strong. Most evaluations of fund-company stewardship follow the precept of "if it ain't broke, don't fix it." Organisations, naturally, are happy to oblige—the status quo being highly comfortable to those who are already in charge. The result being that little happens with fund companies when they are riding high.
The Elephant in the Room
Asset inflows cause three problems for investment managers: scale, competition and scope.
Scale is most easily understood and mostly commonly discussed. Funds can become too big for their britches, so that they begin to move market prices with their trades. At that stage, they must either accept diminished returns or alter their investment approaches.
It's very difficult to judge the effects of scale from the outside. The damages vary not only by strategies, but from manager to manager. Writing broadly, though, PIMCO Total Return has had three scale stages. Before the late 1990s, it was nimble enough to establish meaningful positions in smaller-cap bonds. After that, as the fund swelled, Gross increasingly bet on sectors, credits, interest rates, yield curves and geographies as sources of excess return, as opposed to security selection. The fund then grew again late last decade; since then, its performance has been increasingly driven by the big lever of yield-curve exposure.
Those changes have slowed the fund, so that it no longer can be the spectacular outperformer that it was in the early days, but it retains enough flexibility to be a strong offering, if the execution is sound. It has not been so since 2011; Gross and team have been wrong more than right in their analysis of the Federal Reserve's actions and their effects on the bond market. Those problems are fixable. Whether they will be fixed is another matter, but the fund's scale should not be a barrier to excellence.
The Dogfight
Funds also suffer when their competitors receive money. This argument, most aggressively advanced in the academic article Scale and Skill in Active Management, states that as professional active managers command more assets, the difficulty of outperforming increases. Retail investors are relatively unskilled (or so goes the notion), and passive funds make no attempt at skill, so professional managers are well positioned to profit—except that rival professional managers spoil the fun by chasing the same trades, thereby eroding everybody's profits.
This danger, I think, does not much threaten PIMCO Total Return. Despite the trillions of dollars in professionally managed bond funds, it's still possible for an adroit manager to wallop the indexes. PIMCO Total Return got sector calls right throughout the last decade. It might not do so for the next 10 years—but professional management has not become so ever-present, and so harmful to active performance, as to prevent that possibility.
Scope Creep
Rising scope is the final potential culprit. It's one thing to run the world's largest fund, or even the world's largest bond department. It's another to attempt to manage a diverse, global organisation that is aggressively expanding into additional asset classes and sales channels and building its retirement business. The danger is not only that that organisation might struggle with its new endeavours but also that it might become distracted from its existing efforts.
Did that occur? I don't know. It's the easy and obvious story to tell. Whether that tale is true, however, is another matter. We know that PIMCO was rapidly expanding; that several senior managers had resigned in recent years; and that tensions were high at the top rank. Presumably, those factors were related, as the firm struggled to keep up with its ambitions. After all, when PIMCO was a simpler company a decade before, turnover by senior personnel was lower and Total Return's performance was stronger. But…the sample size is one. Perhaps there's nothing more to the saga than inaccurate yield-curve calls, which could have occurred at any time.
Summary
My view:
1) The PIMCO management change was bound to happen;
2) However, the move required the trigger of weak investment returns;
3) PIMCO Total Return is slowed by its asset size and the growth of competitors, but it remains capable of outperformance.
I also suspect that the switch will work well for both parties. I expect Gross to thrive after being freed of his organisational duties and the PIMCO team to fare better under the new, calmer management structure. That is only a guess, of course. On more-solid ground is the expectation that Gross’ new fund Janus Unconstrained Bond will be relatively freewheeling, as tends to be the case with a small but rising fund, while PIMCO Total Return will be cautiously run. It cannot afford a big mistake.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with his views, his views are his own.
