King of bonds bullish equities

It's rather strange that Bill Gross who makes a living by managing bond fund is bearish bond and bullish equities. The other guru like March Faber has been calling bond market a bubble that is waiting to pop. Read on why the King of Bonds bullish equities.

(Bloomberg)Bill Gross, who runs the world’s biggest mutual fund, takes a seat in a conference room and makes a confession. Overlooking the ocean at the headquarters of Pacific Investment Management Co., Gross describes missteps that doomed his bond firm’s experiment with equities in the mid- 1980s.

At meetings where Pimco set its strategies, Gross’s bond traders overwhelmed the firm’s handful of equity managers, shooting down their bullish arguments promoting stocks. With limited freedom to pursue their own investing ideas, the equity managers quit after about two years, Bloomberg Markets magazine reports in its August issue.

“Those sessions basically said, ‘Hey, we’re a bond shop. This is what we’re going to do. It’s the party line,’” Gross, 66, says. “If I’ve been a problem, then I can be the solution in terms of allowing equity investments to grow and prosper.”

Pimco, which has been synonymous with bonds for almost four decades, is taking another run at equities. It may not be the most propitious time to plunge into stocks. Volatility, as measured by the Chicago Board Options Exchange Volatility Index, was at a 14-month high in late May, as the sovereign debt crisis swept through Europe.

Driving Pimco’s move into equities is Chief Executive Officer Mohamed El-Erian, who says the global economy is entering a period of fundamental transformation he calls the “new normal.”

New Normal

El-Erian says mounting deficits and tighter financial regulation will dampen growth in the U.S. and the euro zone for the next three to five years. Emerging-market nations such as Brazil and China, with stable levels of government debt and expanding middle classes, should continue to thrive, he says.

In the new normal, investors will be faced with anemic returns and they’ll seek alternatives, says El-Erian, who’s embracing several new asset classes. In the past year, he’s presided over the creation of an equity mutual fund and a unit to invest in hedge, real estate and buyout funds. Pimco has also started 10 exchange-traded funds.

“We are living through a remarkable time of change,” says El-Erian, 51, who shares the title of chief investment officer with Gross. “We want to make sure we navigate the changes for our clients.”

Not everyone agrees with this analysis from Newport Beach, California-based Pimco. Some U.S. cabinet officials and securities analysts say El-Erian’s new normal is off the mark.

End to Bond Rally

More than 2,000 forecasters set price estimates showing the Standard & Poor’s 500 Index will jump 26 percent in the 12 months through May 2011 as corporate profits rise, according to data compiled by Bloomberg.

Some investors say the firm might be better off sticking to what it knows best. Gross’s flagship Pimco Total Return Fund, using a complex concoction of bonds, futures and credit-default swaps, has outperformed 97 percent of its fixed-income rivals during the past decade.

“When a fund company expands into new business lines, I get very nervous,” says Martin Weil, whose Healdsburg, California- based MW Investment Strategy Group Inc. manages $30 million, much of it in Pimco funds. “I have a very high degree of respect for Pimco. Am I going to dive into their equity offerings? No, but I’ll take a look.”

The three-decade rally in bonds, the very securities that made Gross famous, will eventually fizzle out, according to Pimco’s outlook. Gross says the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.

Bonds Best Days

“Bonds have seen their best days,” says Gross, who anticipates returns of 4 percent to 5 percent in the new normal.

The king of bonds is now talking up stocks as a better long-term investment. He says that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and, eventually, real estate.

“If you’re talking about the next 10, 15, 20 years, there’s certainly the recognition that assets will grow faster in those categories,” he says. “Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period.”

Gross’s prophecy on bonds may not be coming true anytime soon. Since May, when he warned that European nations like Greece can’t rely on growth to finance their soaring deficits and would likely default, investors have poured into U.S. Treasuries.
Pimco Pathfinder

While Pimco estimates that U.S. debt has the potential to soar to 90 percent of gross domestic product, the country remains a haven for investors. Even Gross increased his Total Return Fund’s holdings of government-related debt, which includes U.S. Treasuries, in May to the highest level since November. The yield on the 10-year Treasury note fell to 3.12 percent as of 5 p.m. yesterday.

Spearheading Pimco’s push into equities is EqS Pathfinder, a global fund the firm launched in April that buys undervalued securities, mainly in Europe. Its only U.S.-based holding in the top 10 positions is SPDR Gold Trust, an ETF that buys gold. Most of Pathfinder’s major positions -- British American Tobacco Plc, French foodmaker Groupe Danone SA and Hong Kong-based Link Real Estate Investment Trust -- derive at least part of their earnings from emerging markets. Pathfinder, which had attracted more than $500 million, declined 1.7 percent in the month ended on June 7, beating 96 percent of similarly managed funds, according to Bloomberg data.

Bond View of Equities

Some analysts say Pimco’s exceptional performance with bonds gives it an advantage with all investments. In Europe, widening bond spreads last year were a warning sign for equity investors of the looming debt crisis, which sent European stocks to an eight-month low on May 25, says Cynthia Steer, chief research strategist at Darien, Connecticut-based Rogerscasey.

“It’s a needed look at equities through the bond view,” says Steer, whose firm oversees $265 billion in assets for institutional investors, many of whom have money with Pimco. “Their research on sovereign debt is excellent, bar none.”

With $1.1 trillion in assets, Pimco is expanding into stocks as part of an effort to lure more individuals to its funds. They’re the fastest-growing group of investors, accounting for 84 percent of all U.S. mutual fund assets at the end of 2009, according to data from the Investment Company Institute in Washington.

Individuals also pay more than institutions. The Total Return Fund charges retail customers annual expenses starting at more than 1 percent of assets compared with less than half of that for institutional and 401(k) investors.

ETFs

Pimco’s income helped fuel the robust results in the first quarter at the asset management unit of its parent, Munich-based insurer Allianz SE. The unit’s operating profit jumped 121 percent to 466 million euros ($555.6 million) from a year earlier -- a figure that helps explain Allianz’s hands-off approach to Pimco.

“They really have left us alone,” Gross says.

As Pimco increases its use of ETFs, it lags behind BlackRock Inc., the world’s biggest fund manager, with $3.36 trillion in assets. New York-based BlackRock last year bought Barclays Global Investors mainly to get iShares, the No. 1 manager of ETFs, with $509 billion in assets.

The securities, which trade on exchanges, have soared in popularity by offering lower taxes and fees than mutual funds. Pimco controls only about $1 billion in its ETFs, with three actively managed bond funds and seven others that track indexes linked to U.S. Treasuries.

Worrier By Nature

The two men responsible for plotting Pimco’s strategy share adjoining desks. Their personalities couldn’t be more different. El-Erian deliberates over almost every decision, while Gross often acts out of instinct. At a round wooden table in a 10- foot-by-10-foot (3-meter-by-3-meter) conference room that served as Pimco’s first bond-trading floor, El-Erian, the son of an Egyptian diplomat, says he’s a worrier by nature. When he was 10 years old, his mother, who’s French and Egyptian, urged him not to take life so seriously.

“She said to me, ‘If you don’t have something to worry about, you create something to worry about,’” says El-Erian, who runs day-to-day operations at the firm of 1,300 employees. He worked over the details of starting stock funds for some two years.

Gross, who directly manages 24 mutual funds, relies on his gut, as well as endless reams of data.

‘Amazing Instinct’

“He is much bolder,” El-Erian says. “He has this amazing instinct. I’ve never seen anything like it.”

Both men get to work at 5 a.m. -- before the start of trading on Wall Street -- and take their seats in the middle of a tightly packed trading floor that overlooks a parking lot. Gross is surrounded by seven computer screens with two stuffed animals -- a bull and bear -- sitting on top of them; El-Erian uses four monitors.

The two leaders rarely speak to one another on the floor. Gross enforces a policy of near silence, sometimes by glaring at offenders who talk too loudly.

“I think Mohamed is respectful of my, sort of, isolation,” says Gross, sitting in the conference room with his blue-and-red printed tie unknotted. “You wouldn’t find me walking around giving high-fives.”

El-Erian, on the other hand, enjoys creating camaraderie around the office. In January, he planned a surprise celebration on the trading floor for Gross. Morningstar Inc. had named him the fixed-income fund manager of the decade after earning a 10- year annualized return of 7.7 percent in the Total Return Fund. The CEO even found a bakery to deliver a cake at 4:45 a.m. As Gross arrived to work, traders erupted in a standing ovation.

Too Much Sugar

“Which is about the last thing he wanted, because then he had to say something,” El-Erian says. Gross spoke briefly, thanking everyone.

Gross, who keeps fit doing yoga and riding a stationary bike for 90 minutes a day, also said he didn’t like to eat that amount of sugar so early in the morning. “It only happens once a decade, so don’t worry about it,” El-Erian responded.

The two executives do constantly communicate, often debating investment ideas, mostly through e-mail. The exchanges go on and on through weekends. “He’s unrelenting and indefatigable,” Gross says.

One thing El-Erian and Gross share is a penchant for publicizing their investment views, which can sometimes move markets. On Nov. 19, Gross wrote in his Investment Outlook on Pimco’s website that utility stocks were attractive with dividend yields of 5 to 6 percent. On that day, the Dow Jones Utilities Average of 15 stocks took off and hit a one-year high in less than a month.

High Jobless Rate

El-Erian frequently touts the new normal on financial news shows and his firm’s website. An economist with a Ph.D. from Oxford University, El-Erian argues that the U.S. faces structural and long-lasting economic burdens, such as massive public debt. He says the U.S. jobless rate -- 9.7 percent in May -- will remain elevated for the foreseeable future. In May 2009, he said that the U.S. economy would expand at an annual rate of 2 percent or less in the next several years -- a forecast he hasn’t revised.

After El-Erian presented his outlook last year, the U.S. economy grew 3 percent in the first quarter, suggesting that the new normal was too pessimistic. El-Erian says the expansion will slow as federal stimulus spending dries up, and May’s job report supports his view. The economy created only 41,000 private- sector positions -- a drop from the 218,000 nongovernment jobs produced in April -- and not enough to make a dent in the unemployment rate.

‘The Old Cyclical’

In an April speech at Princeton University, Christina Romer, head of the White House Council of Economic Advisers, said she found the fatalism of the new normal distressing. Romer said that shorter-term cyclical events like the drop in demand were the real drag on job creation.

“Unemployment is high fundamentally because the economy is producing dramatically below its capacity,” Romer said. “That is, far from being the new normal, it is the old cyclical.”

El-Erian’s biggest challenge may be internal. As the CEO builds a stable of new funds, he’ll have to overcome the embedded bias for bonds that took root in 1971 with the founding of the company. When Gross and his two bond-trading partners left Pacific Mutual Life Insurance Co. to set up their own firm across the street, they decided against taking an equities manager with them.

Legal Scandal

“It would have been better to bring the equity person,” Gross says. “We would have been balanced from the beginning.”

Decades later, the then-parent company of Pimco took a stab at stocks that ended in a legal scandal. In 1999, Pimco Advisors Holdings LP started Pimco Equity Advisors. The stock unit was separate from Gross’s bond shop and didn’t provide any financial benefits. Yet the equity group hoped to get a boost from the success of Gross’s business by taking the Pimco name.

The equity managers got off to a fast start, almost doubling assets to $9.6 billion by 2000 before running into legal trouble. In civil complaints, the Securities and Exchange Commission and New Jersey’s attorney general accused the equity unit in 2004 of allowing a hedge fund to engage in market timing, a practice of making short-term trades to exploit market inefficiencies.

Following the lawsuits, Gross said that he regretted allowing the group to use the Pimco brand. The equity unit, which didn’t admit or deny wrongdoing, paid a combined $68 million in fines and repayments to investors to settle the lawsuits. Allianz dissolved the stock group after the settlements. Allianz spokesman Eduard Stipic declined to comment on the lawsuits beyond previous statements.

Spreadsheet Matrix

Pimco learned a lesson from the fiasco. “We don’t do well when we rent our brand,” El-Erian says.

This time, Pimco will control the equity funds and integrate them into the firm. And, true to form, the CEO in 2008 rolled out an elaborate method to involve every part of Pimco in choosing new assets to manage.

He gave executives a spreadsheet matrix and asked them to use the color green to indicate markets the firm should enter because it has the experience to do so. Yellow meant areas the company should pursue but doesn’t have the know-how. Red signaled businesses to avoid. Portfolio managers used the matrixes to rank ideas for specific funds, and sales reps indicated their clients’ preferences using the colors too.

“We got all these matrices back, we put them on top of each other and we had this overlapping matrix approach that resulted in a road map for Pimco,” El-Erian says. Asset-allocation funds, which invest in a variety of securities, earned a green; equities, a yellow; and direct private-equity investments, a red.

Bearish View

In keeping with Pimco’s bearish view on America, the firm doesn’t plan to create funds with a focus on U.S. blue chips.

“We’re not going to launch a large-cap U.S. fund,” says Neel Kashkari, who heads Pimco’s move into new asset classes.

Kashkari, 36, a former investment banker at Goldman Sachs Group Inc., has no experience in asset management. Then-Treasury Secretary Henry Paulson tapped him in 2008 to oversee the $700 billion Troubled Asset Relief Program.

After TARP bailout money was doled out to banks, Kashkari endured a grilling in Congress. In 2009, Representative Darrell Issa, a California Republican, and other congressmen blasted Kashkari for failing to require transparency on how the banks used the money. Kashkari told lawmakers at the time that TARP was attempting to increase its transparency.

IMF

He resigned in May 2009 as part of the outgoing Bush administration. As of the end of March, 77 TARP recipients had paid back $180.8 billion of the $496.8 billion the fund has distributed.

“Given my experience building the TARP from scratch, I wanted to build new businesses in the private sector,” says Kashkari, who declined to elaborate on the bailout program. At Pimco, he plans to start fewer than 10 equity funds in the near future. “You will see us offer a handful of strategies that are global,” he says.

El-Erian forged his career analyzing the global economy, first at the International Monetary Fund in 1983. A former colleague says El-Erian was known for a work ethic that once kept both of them up until 3 a.m. writing a research report. He ascended from an entry-level post to become chief of staff to Stanley Fischer, then the No. 2 IMF official, in 1994.

“He was just terrific in that job,” says Fischer, 66, who’s now governor of the Bank of Israel. “The only problem I had with him was, he wasn’t in the job long enough.”

Salomon Smith Barney

After less than a year with Fischer, El-Erian became deputy director of the Middle East department, a job he held until he joined Salomon Smith Barney in January 1998.

As the European head of emerging-market research at Salomon in London, El-Erian made a prescient call on Russia. In early 1998, he said the country would default on its sovereign debt and devalue the ruble. In making his case to clients, El-Erian said Russian credit was deteriorating and the nation’s regulators didn’t have the flexibility to respond. Russia defaulted in August 1998.

Gross offered El-Erian the job of managing Pimco’s emerging-markets portfolio three months later. From April 1999, when he joined Pimco, to the middle of 2004, his flagship Emerging Markets Bond Fund posted an annualized return of 21.3 percent.

The Harvard Management Co. board hired El-Erian in October 2005 to be CEO and revamp the university’s endowment, which was in turmoil. Prior to El-Erian’s arrival, about 30 managers, including the entire fixed-income team, and CEO Jack Meyer had left amid criticism from alumni who said they were overpaid. Some managers had pocketed as much as $35 million a year.

Tail-Risk Hedging

Under El-Erian, the payroll went down as he hired managers who were compensated using an existing formula that paid new employees less. El-Erian was the top earner at the endowment in fiscal 2007, making $6.5 million.

In overseeing teams at Harvard that focused on U.S. and emerging-market equities as well as real estate and commodities, El-Erian gained experience that would help him lead Pimco’s expansion. At Harvard, in addition to creating a foreign- exchange group, he developed tail-risk hedging, which involved using portfolio insurance to try to protect investors from unexpected events that would hammer markets. In fiscal 2007, the then-$34.9 billion endowment posted a 23 percent return.

El-Erian says he didn’t realize a financial tsunami would devastate markets a year later when he announced his departure in September 2007. At the time, mortgage delinquencies were rising and credit markets were just beginning to tighten.

‘Plan for Succession’

“I had no idea that such a big crisis was coming,” he says. “If I knew, I would have stayed there.”

The endowment performed well for months after El-Erian left for Pimco in December 2007. It rose 8.6 percent while the S&P lost almost 15 percent in the fiscal year ended on June 30, 2008.

Six months later, Harvard began to go into a financial tailspin and would pay banks almost $1 billion to terminate wrong-way bets on interest-rate swaps made prior to El-Erian’s arrival. The endowment, down to $26 billion, fell 27.3 percent in fiscal 2009.

Gross, then 64, brought back El-Erian to be co-CEO with William Thompson, who retired at the end of 2008. “Your most important job, certainly in your 60s, is to plan for succession,” Gross says. “We knew that Mohamed could fill an important part of the puzzle.”

World’s Biggest Fund

The $227.9 billion Total Return Fund became the world’s biggest mutual fund in 2009, as Gross lured in investors with his handling of the financial crisis. Gross saw the mortgage debacle coming and was able to dodge most of the damage -- thanks partly to yoga.

In 2005, he suspected a housing bubble had formed. During a yoga session, it occurred to him to send analysts posing as homebuyers into the field to test his theory. The research helped him decide as early as 2005 to avoid subprime-mortgage- backed securities.

While Gross shunned subprime debt, he hasn’t shied away from other complex investments in his Total Return Fund. Morningstar analyst Eric Jacobson says the manager boosts returns partly by using derivatives -- contracts whose value is derived from stocks, bonds, loans and currencies.

Gross increased his holdings of CDSs in 2009 as the sovereign-debt crisis began to shake Europe. The fund sold insurance on credit from countries such as Italy and the U.K. and almost doubled its CDSs on sovereign debt to about $1.4 billion on Dec. 31 compared with three months earlier, according to Pimco’s February filing with the SEC. The manager boosted his bet in the first quarter, selling default protection covering almost $5 billion in sovereign debt on countries such as Brazil, France, Panama and the U.K.

Forward Contracts

Gross also buys forward contracts or futures on Eurodollars, Treasuries and other investments, typically putting down a 5 percent to 6 percent margin deposit, according to Pimco filings. He then deploys the money that he saved by not buying the actual investments in short-term cash equivalents such as commercial paper, Jacobson says. The fund owns no bonds from Greece, Portugal or Spain.

Lawrence Weinman, an independent financial adviser who manages about $20 million in Los Angeles, steers his clients away from Gross’s handiwork. “You don’t know what’s in it,” says Weinman, who worked at Morgan Stanley and Societe Generale SA. “Putting money in with Bill Gross and saying, ‘Just put it anywhere you want,’ is not the way I advise people to invest money.”

Market Manipulation

Some traders accuse Pimco of crossing the line from market influence to market manipulation. In a lawsuit filed in 2005, two individual investors and a derivatives-trading firm claim that Pimco artificially drove up prices of Treasury futures on the Chicago Board of Trade.

The suit claims that Pimco bought $16 billion worth of 10- year Treasury futures and then hoarded a majority of the most desirable notes underlying those contracts to drive up the value of securities traders needed to fulfill their futures agreements. The plaintiffs, who are seeking $600 million, had sold the contracts short and claim they had to pay higher prices to replace them.

The U.S. Supreme Court in February let stand a federal appeals court ruling that the traders who filed the lawsuit in Chicago could pursue the litigation as a class action. Pimco denies the allegations.

‘Drip, Drip Approach’

“The plaintiffs include hedge funds and other sophisticated investors who made speculative investments and are now trying to profit from what turned out to be their bad bets,” a Pimco spokesman says.

Pimco won’t become a powerhouse in equities anytime soon. The company has hired only about 12 executives, managers and analysts to work in stocks, ETFs and funds of funds, with plans to add several more.

“In terms of the drip, drip approach of doing this slow, I can’t say it’s going to be successful,” Jacobson says. “But they want to make sure everybody they bring in is not only Pimco caliber, but also Pimco style in their thinking.”

El-Erian says he’s expanding cautiously to avoid damaging the main bond business upon which Pimco is built. “We are very careful not to dilute what has served our clients well,” he says. “And that comes from being very realistic about what you can deliver.”

Anne Gudefin and Charles Lahr, the value-oriented managers who run Pimco EqS Pathfinder, aren’t in a hurry to buy stocks. In December, El-Erian hired the duo, who had managed Franklin Templeton Investment’s Mutual Global Discovery Fund. Their Pathfinder fund held about 22 percent of its assets in cash as of the end of April.

‘We’ve Grown Up’

Following the 10 percent plunge in the MSCI World Index in April and May, the managers may deploy more money. “We’re happy to say that the current sell-off is highlighting some interesting opportunities,” the managers said in an e-mail.

Thirty-nine years after he founded Pimco, Gross says the firm’s new funds are a sign of his own evolution.

“It simply means perhaps we’ve grown up, and I have,” he says. “I’m 66 now and recognize there are lots of different pieces to a puzzle and they each have a right to a place in the capital markets.”

Gross says he has no plans to retire. But as he prepares for succession, this may be one of the last chances for the king of bonds to help his equity managers thrive and share the Pimco limelight.