At the core of Bill Gross’s (and Pimco’s) investment philosophy was a drive to
be more aggressive on every front — more aggressive on risk taking and leverage, more aggressive at Wall Street sales in the name of better execution, more aggressive in the gray areas of terminology, mandates, regulations.
That quote comes from Mary Childs in her book, The Bond King, which was introduced in the last posting. In this one, we will look at how the firm’s aggressive mentality played out in different ways.
The backdrop
Pimco started in 1971 as a part of Pacific Life Insurance, at the dawn of a new era in financial markets — and in fixed income investment management in particular. Over the next fifteen years, bond investing would move from being dominated by buy-and-hold investors to those seeking total return. Pimco was in the forefront of those changes.
The mortgage-backed securities market came into being. High yield bonds went from the province of a few deep-value investors to undreamed-of popularity. International bond trading increased dramatically. Derivatives came onto the scene. And the systems to analyze and manage portfolios reached new levels of sophistication.
Bond managers more actively traded one corporate bond for another to pick up a few basis points of yield or to move to a more creditworthy borrower or to own something with better covenants. They made more yield curve bets. And they started choosing among all of those new vehicles and sectors and strategies, changing their exposures to capture returns in whatever way they could.
Before, the toolbox for creating portfolios had just a couple basic implements. Now it was overflowing with possibilities.
Hunting for edges
A hallmark of Pimco’s success was its willingness to look in every direction to add value. Here are some of the notable examples provided in Childs’s book.
Forcing delivery of futures. This play was emblematic of the firm’s ways:
Pimco had put itself on the map in the 1980s with a feat that was so complicated, so elegant, so comprehensively and forcefully effective that it felt like it had to be a miracle. That one trade established its reputation on the Street as an intimidating trading partner, someone who might rip your face off more than the average counterparty without your knowing it had removed your face until long after.
In 1983, the little band of traders [at Pimco] orchestrated a perfectly legal stunt in the mortgage futures market.
The bottom line was that Pimco understood mortgage bond futures and the terms of the underlying securities in a way no one else did. Those futures could be settled in cash (which was what normally happened) or you could have mortgages securities delivered to you — getting the actual certificates for them. Market participants tracked the “cheapest-to-deliver” security to facilitate the process and keep the price of the futures in line with those of the mortgages that were likely to be delivered.
The Pimco tale includes the discovery of the opportunity (hiding in plain sight for anyone to find); a further period of research to make sure they weren’t “imagining things or missing something crucial;” registration as a commodity trading advisor to be able to execute the trades (which meant a number of people had to take and pass the relevant exam so the firm would qualify); convincing clients to set up a futures account to participate; carefully implementing the trade without alerting others to the opportunity; and forcing delivery, which included going to a bank in Chicago to pick up duffle bags of Ginnie Mae certificates.
It was a windfall, as Pimco anticipated. It had been the only firm that realized that there weren’t enough of the cheapest-to-deliver securities available, meaning that other, more valuable ones would be used to fulfill the contract.
(Twelve years later, another cheapest-to-deliver play — this time involving Pimco buying up a good share of the specific bond that people expected to be delivered to satisfy a Treasury futures contract — resulted in a massive payday.)
Operational strength. All of those new kinds of bonds (but especially mortgage-backed securities) required more sophisticated accounting and operational systems. Some other firms were slow to upgrade, but not Pimco. Pat Fisher led the way:
The efficient systems that could handle complex accounting, the perfect trade execution — her operations facilitated the differentiated trading that made the stellar track records.
Her work enabled the blockbuster mortgage trade. Another simple but important innovation was a bank-rating system, “because you’re only as strong as your weakest link.” She let banks know about it; “they jockeyed to be the best.”
Pimco wanted to excel at every dimension of investment management, including operations. Fisher was instrumental in making that happen.
Trading. The book is replete with examples of Pimco squeezing the Street on trades. For most firms, it is the other way around, but as it grew bigger, Gross felt that the Street needed Pimco. For the volume of trades it did, for the liquidity it provided, and for the information that could be gleaned from its maneuvers. So Pimco traders were expected to get the best possible price every time (and Gross often didn’t think it was good enough), to the extent that the traders had trouble getting jobs elsewhere because they had burned so many bridges.
Structural alpha. Gross always looked for small advantages that would compound over time. For example, in what ways could the cash component of a portfolio be used to add value? By expanding the notion of cash to include “cash equivalents” that stretched the “equivalents” description — or by using the cash as margin for futures positions, to apply a little leverage to the portfolio. Routinely selling volatility was another tactic. All of this became known as “structural alpha,” there day in and day out.
Non-benchmark bonds. Like many other managers, Pimco benefited from easy comparisons, since its portfolios included a variety of investment vehicles that weren’t in the index used as its benchmark. All of those new options in the toolbox offered ways to set yourself apart, and most of them outperformed during the decades-long move to lower rates.
The Total Return ETF. In 2012, Pimco launched an ETF based upon the flagship Total Return mutual fund managed by Gross. For years, Pimco had taken advantage of Rule 17a-7 of the Investment Company Act of 1940, which “allowed for cross-trading among a family of funds,” provided it happened at market prices. But bond pricing was not a science and pricing services often lagged, so such movements could provide an advantage to one fund over another.
However, even the normally aggressive Pimco decided not to use such transfers to seed the ETF, since:
there were too many eyes on the new product. “Compliance [is] especially sensitive given visibility of this ETF launch and likely focus by bloggers and/or regulators,” the structured products guy wrote to Gross. So “17a-7-ing” the bonds into the Total Return ETF would be off-limits.
But there was another way to show good numbers out of the gate, one common with new bond funds. Gross sent a note to traders: “cheap odd lots preferred.” He backed it up with some rewards when the traders found them. The tactic was good with compliance because “the pricing group had signed off on it.”
Pimco trumpeted the strong early returns as evidence that a manager of an active ETF could add value. Childs wasn’t so sure:
True, sort of! The “value” they were “adding” looked suspiciously like buying bonds at one price and then reporting them at a higher price.
Whatever you called it, Pimco was good at finding and exploiting the opportunities that were available.
The housing bust. The first chapter of the book, “The Housing Project,” details Pimco’s early concerns about the state of the housing market in advance of the financial crisis. Gross sent analysts to different parts of the country to pose as prospective homebuyers. He later talked about what they found: “The extent of the lending malpractice — to use a nice word — was shocking.”
Paul McCulley of Pimco mapped out “the shadow banking system” that supported it all, that hid the rot in the system. He warned of a “Minsky moment”: “It’s all connected. The whole thing is going to blow.”
But the market wasn’t seeing it yet, and people elsewhere kept putting on risk, so getting conservative too early would mean underperforming until things came apart, if they came apart. That’s why most portfolio managers don’t want to make big portfolio moves even if they sense a risky environment ahead. But Pimco did it.
Scale
As the firm grew larger and larger, concerns about its scale became more widespread. But Gross pooh-poohed them:
He always insisted that Pimco could keep performing thanks to its “structural” approach: its three- to five-year view; its machine of small-but-effective trades; its carefully but consistently taking more risk than everybody else, pressing every dollar for an extra penning, pressing every dealer for an extra basis point, converting minutes into money.
“Doing things that others weren’t willing to do” was a structural trade of sorts too, a mindset that permeated everything about the firm.
Read the documents. Do real due diligence. If you find something that others haven’t found, be bold.
Look for advantages wherever and whenever and however, including the ones that massive scale makes possible and the ones facilitated by fame.
Narrative power, market power
As mentioned in the first posting, Gross used his notoriety to good effect.
Childs references an appearance by Gross on CNBC five minutes before an auction of TIPS (Treasury inflation-protected securities), saying he saw little value in them. But it turned out Pimco had put in a huge bid for TIPS at the auction. Coincidence?
During the financial crisis, the Pimco line was that “Fannie and Freddie [the big mortgage agencies] were inherently unstable and that the Fed and maybe Treasury would need to pump money into them.” Again, Gross was on CNBC, lobbying for action. The Treasury responded a few days later, in the way that Pimco had argued it should do; “Everyone with investments below Pimco in the capital structure got wiped out.”
Gross has denied any back-channel deals — “we were bullies in the trading room, but we weren’t bullies from the standpoint of, you know, Treasury strategy” — but the moves worked to Pimco’s advantage. Also during the crisis, the government hired the firm to execute trades for a couple of its rescue programs — and Pimco “called the government’s bluff” regarding GMAC and AIG (good gambles as it turned out). All of it taken together made market participants wonder about front-running possibilities for Pimco and the undue influence it appeared to have at a time of worldwide financial trauma.
No wonder Gross gained a reputation as a man “who could bend markets and politicians to his will.”
Seizing the opportunity
Given the nature of markets, not all of the trades worked. And Pimco repeatedly struggled in some areas outside of its core expertise — especially with regard to equities, which it could never get right. But overall, the firm charged forward to create one of the great success stories in the history of the investment industry.
It must be said that the timing for its coming into existence was perfect. The proliferation of new securities to trade, the embrace of the total return philosophy by investors, and — the big one — the incredible move lower in interest rates, all of which provided powerful tailwinds. It’s rare that so much opportunity presents itself at one point in time; certainly that’s the case today, in an era of more efficient markets.
Yet Gross and Pimco seized the day in a way that others did not. Every angle was probed, every advantage was pressed, and every basis point was tallied to make sure they were still winning.
Published: May 21, 2022
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