More Questions About PIMCO in the Post El-Erian Era

Questions surrounding Mohamed El-Erian's recently announced departure and the flurry of other personnel changes that followed at PIMCO continue to proliferate, and, if anything, that trend has intensified over the past week. Morningstar has been fielding those questions left and right, from audiences as diverse as individual investors, advisors, institutions, and the press. A number of themes have come up consistently in these conversations, and we thought it worthwhile to address a few of them here along with Morningstar's preliminary thoughts on the current situation at PIMCO.

How much of an effect did the market calls made by PIMCO over the past year have on Mohamed El-Erian's departure?
The official version from PIMCO is that El-Erian's departure was purely a personal decision and that it had nothing to do with last year's performance. That said, it makes sense to consider what’s gone on not only over the past year, but what’s occurred over the past few years, given that there was some difficulty, particularly in the third quarter of 2011, with some of the calls that the firm made.

First, it seems unlikely that performance during that 2011 period would necessarily be hung around El-Erian's neck, because Bill Gross took a lot of responsibility for it.

The volatility that many of the firm’s funds suffered in the summer of 2013 was certainly disturbing for some investors as well, especially when looking at some of the funds' category standings and relative performance, and the fact that people have come to expect so much from PIMCO and Bill Gross.

There are a couple of relevant issues to examine there, however. One is that the summer volatility didn't do as much damage to PIMCO Total Return Instl (PTTRX), in particular, as some press reports have implied. There has been a big focus on the fact that 2013 was the fund's worst calendar-year loss since 1994. What has been nearly absent from that conversation, however, is that it was also the Barclays U.S. Aggregate bond benchmark's worst loss since 1994, as well, yet Total Return still edged past the index by 0.10% last year.

Perhaps more important is that none of that difficulty appears anywhere near sufficient to justify deliberately making the waves that El-Erian's departure did. Eliminating someone so senior, so identified as a face of the firm, and so crucial to its reputation simply doesn't seem to be anywhere near worth the cost that PIMCO is now paying in terms of investor trepidation about its future.

What are the most notable implications of El-Erian's departure for the management of PIMCO's funds?
That's really two questions in one: How will his departure affect the few mutual funds that he has been managing directly, and how will it affect PIMCO's all-important investment committee.

As for the funds on which El-Erian is a named manager, there's not much reason for concern. There are actually just a couple of them, and while this is certainly an issue for shareholders of those funds, the amount of assets in those portfolios is relatively small compared with the rest of the firm and PIMCO Total Return, and the new managers have outstanding credentials.

That said, Lupin Rahman, a well-respected emerging-markets expert, is taking El-Erian's spot as a comanager for PIMCO Global Advantage Strategy (PSAIX), while Mihir Worah, the firm's real-return chief, is moving into El-Erian's place at PIMCO Global Multi-Asset (PGAIX).

Each of them brings an eye-popping resume to the table. Rahman herself has an El-Erian-like background: She holds a Ph.D. in economics from the London School of Economics, boasts years of experience at both the World Bank and the International Monetary Fund, and has been impressing her colleagues at PIMCO since 2008. Worah is no slouch either, having originally come from academia with a Ph.D. in theoretical physics and spending his first years at PIMCO on the firm's analytics team working on interest-rate models and options pricing. He cut his portfolio-management teeth on PIMCO's real-return offerings working under inflation-protection luminary John Brynjolfsson (now at Armored Wolf) and has become an industry leader in his own right since Brynjolfsson left the firm.

The bottom line is that both managers are indisputably sharp and have excellent reputations, and Worah has built excellent records at his funds, including the Gold-Rated PIMCO Real Return (PRRIX). If anything, both funds had struggles under El-Erian, so despite the loss of such a high profile manager, it might very well prove advantageous to have their teams shaken up a bit.

PIMCO's Investment Committee: The Heart of the Beast
The second, even bigger question is how El-Erian's departure will affect PIMCO's investment committee. That's such a crucial issue because he has been one of the most senior people on that committee along with Bill Gross, and he frequently ran its meetings and set its tone. His participation became front and center after he returned to the firm as co-CIO in 2007 (after two years running Harvard's endowment), and he began to play a big role in choosing other members of the group. As such, the main drawback surrounding the committee that remains in place, and even accounting for the addition of new members, is that few of them have been as senior and long-tenured as El-Erian.

That situation has been exacerbated by significant departures from the firm in recent years. In 2010 it was Paul McCulley, mainly known outside the company as a Fed watcher but one who was very involved in the investment committee and ran PIMCO's cyclical forums. His input was clearly crucial, and it was evident that he played an important role in challenging and debating other members of the group, especially Bill Gross, Chris Dialynas, and El-Erian. Dialynas has been another important voice on the committee, but he, too, has stepped down, at least for now. He had been the portfolio manager of PIMCO Unconstrained Bond (PFIUX) as well as a very senior, long-tenured manager with a strong, opinionated voice on the committee, and it was clear that he, too, played a balancing role in the group. He announced a sabbatical late last year that is now slated to begin in April. And though PIMCO has hinted that it could be for only a year or so, he took a much longer leave in the 1990s, and it hasn't been said whether he would rejoin the investment committee, if and when he does return to the firm.

A Silver Lining
There are reasons to be optimistic, though.

Gross and PIMCO quickly appointed two deputy CIOs after El-Erian's announcement and added four more a bit more than a week later. Five of the six are fixed-income managers, each of whom has been added to the investment committee as well. Two of them--Dan Ivascyn at PIMCO Income (PIMIX), and Mark Kiesel who runs PIMCO Investment Grade Corporate (PIGIX)--are recent recipients of Morningstar's Fund Manager of the Year award for fixed-income, and Scott Mather, who runs a variety of funds including PIMCO Global Bond (USD-Hedged) (PGBIX) was a finalist for the honor in 2011. To a person they are an extremely impressive bunch, and nearly all of them have helped build strong records at funds on which they are listed managers or work in support roles.

Perhaps the most compelling argument for the addition of these deputy CIOs to the investment committee is that most bring a bottom-up analytical, sector, and market perspective that has not otherwise been the focus of the group in recent years. It's impossible to say for sure whether the firm's late-2011 and summer-2013 stumbles would or could have been avoided by the injection of such contributions to the group, but those elements appear to bring some much-needed balance to the committee.

Although PIMCO's sector desk heads were all once members of the committee, for example, that format changed some years ago. Instead, the group has since been dominated by macro specialists and discussions, and its emphasis has been on interpreting the winds of global economics. As PIMCO has been quick to point out, there has certainly been bottom-up input into the committee's deliberations in the form of guest presentations and the rotation of nonpermanent members in and out of the group, but those topics haven't always been at the center of the debate.

There will now be nine permanent members of the investment committee, and though several of them could conceivably count as both economic and fundamental specialists, it's evident that both elements are more broadly represented than before. In particular, while Gross, Tony Crescenzi (another newly appointed standing member), Saumil Parikh, and Andrew Balls might be first described as macro thinkers despite the broader experiences of each, Kiesel, Mather, Worah, Ivascyn, and Christian Stracke (global head of credit research) unequivocally bring the kind of bottom-up experience and orientation that had been de-emphasized for some time.

The Emperor's New Clothes
The firm's investment committee is about to embark on an entirely new era, and despite the firestorm out of which its new shape has been forged, the group's new composition could theoretically have the right ingredients to put PIMCO on just as impressive a path it has cut for the majority of its history.

Will any or all of them prove to be an effective counterbalance and challenger to Bill Gross’ thoughts and ideas? Will they be comfortable enough and their perceived stature tall enough to foster the necessary confidence required to stand up to Gross?

He has made a compelling case over the years that he values that that kind of pushback and the critical devil's advocate role that it serves. It has been institutionalized formally, at least, into PIMCO's process, particularly in the form of a shadow committee that serves to challenge the assumptions of the main body.

That's a difficult enough environment to navigate even for a senior peer of Bill Gross, though. One can only imagine that it might be orders of magnitude more so for younger, shorter-tenured members of the group--though we're still talking about experienced, accomplished professionals--who may not feel as bold, confident, or intrepid.

The $64,000 question is how well the new members of the investment Committee will adapt to facing down Bill Gross day in and day out. Despite his usual public appearance of tranquility (and the fact that he's a devotee of yoga), it is strongly reputed that Gross does not suffer thinking that he deems facile or poorly reasoned. If PIMCO as a whole is a pressure cooker for employees--and by all accounts it is--one can only conclude that its investment committee has the potential to feel like one of the last circles of Hell.

Eric Jacobson has a position in the following securities mentioned above: PTTRX