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A model fund manager must be beyond reproach
Pimco star bond-fund manager, Bill Gross, has long occupied the moral high ground and earned his investors' trust. All the more reason to own up to lapses, even the trivial ones.
By Timothy Middleton
Bill Gross, manager of the worlds largest bond fund, has a reputation for lecturing business titans on their misdeeds. Now his company, Pimco, stands accused of them, and hes outraged, demanding a divorce from a sister company also accused in the same complaint by the New Jersey attorney general.
I know Gross well, and in fact, wrote a book about him thats being published this month. I spoke with him after his company was dragged into the mutual fund scandals, and I sympathize with his plight. But I think hes wrong. Pimcos skirts are dirty.
The lawsuit filed by New Jerseys attorney general is mainly aimed at other companies carrying the Pimco brand -- hence Gross's call for a divorce -- but it appears to be dead-on in identifying a problem at Pimco. If the charges are true, and Pimco insists they aren't, the company explicitly agreed to allow market-timers into the companys bond funds despite disparaging timing in their prospectuses.
Slight, not trivial
Timing has become a word the Supreme Court shouldnt allow to be shouted in a crowded theater; its inflammatory. Timing is actually a legitimate investment tactic. I recently sold a Gross-managed bond fund for reasons that can only be described as timing.
But I didnt sell it intending to buy it back within a month, and then do the same thing the month after that, which is what New Jersey alleges and Pimco doesnt dispute. That kind of short-term trading is bad in mutual funds. Its goal is to skim a portion of profits earned by long-term investments without enduring the wait. It can boost costs for a fund because it increases trading expenses.
Of all the scandals that have swept through the fund industry since New York's attorney general turned the spotlight on unsavory practices last September, the one attributed to Pimco is among the slightest. But that doesnt mean its trivial.
As an investor, Im waiting for Pimco to stop bellyaching and recognize that a model mutual fund manager should be beyond reproach.
Two schemes
Pimco, the bond firm, traces its roots to the 1970s. It became so successful in the 1990s that Allianz (AZ, news, msgs), the Germany insurer, paid $3.5 billion for a controlling interest. It then slapped the Pimco brand name on a host of unrelated companies.
New Jerseys lawsuit is aimed at three of them, in addition to Pimco: an equity fund firm named PEA Capital, a distribution company named Pimco Advisors Distributors and the U.S. office of Allianz.
It describes what it calls two schemes. The first involves PEA and the distribution company, alleging they accepted $100 million from a hedge fund, Canary Capital Partners, which planned to market time several equity funds in return for leaving $25 million in so-called sticky assets in a struggling fund that was subsequently merged into Pimco PEA Growth (PGWAX).
Canary, a New Jersey-based fund run by the Stern family of Hartz Mountain fame, is the hedge fund identified with market-timing at a number of other fund companies.
PEA is also alleged to have shared nonpublic information about its portfolios with Canarys representatives. According to The Los Angeles Times, PEA has agreed to reimburse shareholders in one tainted fund $1.2 million, but asserted they werent harmed in three others.
In the second New Jersey charge, Pimco is alleged to have entered into its own deal with Canary, allowing the hedge fund to time up to $80 million in two bond funds, Pimco High Yield (PHDAX) and Pimco Real Return (PRTNX). Between timing transactions, the money was parked in a money market or two other funds, Pimco Short-Term Bond (PSHAX) and Pimco Low Duration (PTLAX), which is managed by Gross. He isn't named in the complaint.
The only incentive Pimco was alleged to have received from Canary was management fees it earned while the funds were on account, which was a one-year period that ended Sept. 11.
The smoking gun in New Jerseys allegation is what purports to be an e-mail dated Oct. 1, 2002, from David Hinman, at the time a portfolio manager on the team that runs the high-yield fund. Addressed to another Pimco employee, it says, We can handle $20MM in timer money. The amount was subsequently raised.
Pimco officials are also quoted in various documents as authorizing Canary to trade as often as once a month in the two funds. The funds' prospectuses, in identical language, limit round trips, purchases and redemptions to no more than six per year.
Dramatically misleading
The New Jersey lawsuit is often dramatically misleading. For example, it alleges that
some 45 transactions occurred in the Real Return fund, but they're shown in an accompanying exhibit to have been only three round trips into and out of the fund in each of three Canary accounts. The other transactions were the switches in and out of the money market, as well as dividends received.
The profits the lawsuit attributes to Canary for its efforts at Pimco amount to about $4 million over a years time; Canary jerked the accounts after it was exposed in related litigation by the New York attorney general Sept. 3.
On an investment of $80 million, thats a return of 5%, less than one of the funds, Real Return, delivered in that period (5.9%), and far less than the 21.2% returned by the second, Pimco High-Yield.
Pimcos retort is that it actively discourages market timing. Indeed, the lawsuit itself acknowledges in the section on PEA that when Canary tried, through the distribution company, to use Pimcos bond funds to park that timing money it was identified by Pimco and expelled within days.
Canary was not given special trading privileges, Gross insists. It was given more restrictive trading privileges. Never, in our opinion, has a client been granted special trading privileges.
Gross also says he was never consulted on the Canary agreement, and didnt learn of it until after the New York suit had become public.
Into the mud
Grosss view is that Pimco has been dragged into the mud by PEA Capital, whose funds are sold under the Pimco brand name, as are those of several other equity investment firms. We think weve done nothing wrong, he says.
At some point down the road were going to talk to Allianz about a separation, because we have no control, no communications link, no dealings with these people, he adds. Grosss funds account for the lions share of assets managed under the Pimco brand.
In my prior coverage of funds dragged into scandal, Ive often recommended selling them if they betray their shareholders. I dont think Grosss Pimco has done that. I think it at least suggested a willingness to violate its prospectuses, although Canarys trading as outlined in the lawsuit was so light it didn't appear to violate them in fact.
Until recently, I owned a Gross-managed portfolio, Fremont Bond (FBDFX), a no-load fund managed in the same style as Grosss flagship, Pimco Total Return (PTTAX). I sold it in January, before this story broke, when I switched my personal bond money into closed-end municipal funds.
I did so, as I explained in a column at that time, because I expect interest rates to rise, hurting the Fremont fund more than the closed-ends. When the interest-rate outlook is more benign, later in the business cycle, I expect Ill buy the Fremont fund back.
Pimco has been burned by this controversy and wont play with those matches again.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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