Reposting: The Bond King and His Kingdom

Sampler postings republish essays previously available only to paid subscribers.
This is compilation of four postings from May and June, lightly edited
to eliminate context that served to connect the separate pieces.

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Posting one:  “Cult and Culture in the Bond Kingdom”

The story of Bill Gross and Pimco is told in The Bond King, a book by Mary Childs published in March of this year.  In the introduction, Childs writes that it “is not a comprehensive history of Pimco” (thankfully, since such a tome would be unwieldy), but it provides a well-reported look at a man and a firm that have been at the center of market action and industry competition for decades.

This is the first of four postings about the book, which are not intended to summarize it but to explore some of its implications for investment organizations and those who evaluate them.

Organizational dynamics

All organizations are messy, even highly successful ones.  The Bond King recounts plenty of the drama at Pimco — and sets up essential questions about the nature of investment organizations and what it takes to win in the market made up of securities and in the one made up of managers.

Pimco was founded by a “three-legged stool” of leaders.  That’s in contrast to many new asset managers, which are dominated from the beginning by one person with a track record and perhaps some measure of fame.  But who can name the two other than Gross?

As the chief investment officer, he became the face of the firm and he got the credit for its success.  John Wooden, the legendary basketball coach at UCLA, said, “The main ingredient of stardom is the rest of the team,” but in the investment world (as in sports) it’s those stars who get the glory.  That external recognition reinforces their power within their organization.  Business decision making can easily become more concentrated and one-dimensional, especially as other key people leave over time.

For many firms that’s a fatal flaw, although in some cases the death is a slow one, happening over many years, while others seem to come out of nowhere.  When a person is more important than the firm, an imbalance exists that will resolve itself sooner or later.

This is how Childs characterizes Gross’s point of view as his reign at Pimco looked like it might be coming to an end:

No matter how much Pimco management wanted to rein him in, they couldn’t risk his quitting, not amid all the turmoil.  It would destroy the firm.  It was his trump card.

He saw “that Pimco was his, and Pimco was him.”

While those are Childs’s words, they capture the mindset at work at many firms.  In a New York Times interview, she said,  “A lot of these founder-led companies depend so heavily on the founder, and he or she can kind of act however they want.”

Culture

The book is a window onto the Pimco culture and, to a certain extent, the cultural norms of the investment industry.  Therefore, it serves as a platform for examining both specific and general questions about those norms.

There are many elements of culture.  The day-to-day work environment is full of clues.  At Pimco, the trading room reflected Gross’s need for quiet, so that he could think.  Louder people were moved further away from his desk.  Communication was usually by email, even if someone was a few feet away.

In some organizations, that sort of hushed habitat indicates a studious, collegial approach.  That was not the case at Pimco:

Serene for him, maybe, but his personality mangled whatever peace the rest of them could have enjoyed.  The place was suffused with Gross’s clinical insecurity that someone might catch up, that someone might threaten Pimco’s dominance.

Those emails from Gross — and the direct personal interactions with him — demanded fast answers and conviction.  “Your ass was always on the line,” is how Childs summarizes it.  And:  “Grown men had been brought to tears.”

The byproduct of his approach was a cutthroat, often merciless environment that could chew people up and spit them out, like the “sweet statistics nerd [who] left twisted, broken, full of rage.”

Gross is quoted as saying, “Maybe there should be a grain of sand in the oyster to produce the pearl, maybe there should be some conflict.”  But how much was too much?  What’s the right recipe?  What are the effects of a win-at-all-costs mentality?

After the infighting at Pimco became public, Marc Andreessen said:

The behavior described is completely typical of any highly-successful, high-functioning organization in any field I’ve ever seen.  [They] aren’t Disneyland.  There’s always stress, conflict, argument, dissent.  Emotion.  Drama.

Where is the line?  At what point does productive tension become destructive infighting?  When do the land mines that have been planted start blowing up?

Gross himself had earlier declared, “Pimco is less likely to explode externally from the ingestion of too many assets than it is to implode internally from a self-induced ulcer.”

Cult

Many investment managers keep their private lives close to the vest, but Gross would sometimes bare his innermost thoughts in his monthly Investment Outlook pieces.  And at times he would say things at conferences that would raise eyebrows.

Childs delves into some of that and offers a multi-faceted look at his personality and behavior.  They have also been the topic of articles by others (and Gross has weighed in himself, as during a Masters in Business podcast), so we won’t go into it any further here.

Despite his quirks and his challenging nature, Gross led a wildly successful firm for more than thirty years, which engendered devotion to him within it.  He might have been an odd duck, but he was the odd duck that laid the golden eggs.

The same kind of admiration grew and grew among investors and gatekeepers and members of the media.  Once he became known as “the Bond King,” it intensified.

Kingdom

Always willing to use narrative to achieve his goals (more on that in the next posting), Gross has said that he wasn’t going to disabuse anyone of the notion that he was, in fact, the Bond King.

He readily admits that being famous was always his goal, and he used his fame like a weapon.

History has shown that investors have trouble maintaining objectivity when it comes to investment managers.  They can fall hopelessly in love, especially with the acknowledged greats.  They even are willing to forgive a manager’s quirks as part of the package you get when you do business with a genius.

Gross was viewed as the king of the bond market, the person who had solved it and, through his use of influence and market power, had even controlled it at times.  His kingdom was vast, but, as he had predicted, it was vulnerable from within.

Secretariat and the diplomat

Many people move in and out of Childs’s story across the decades, but one matters more than all of the others:  Mohamed El-Erian.

El-Erian had worked at Pimco previously, but he left for a short stint as the head of the Harvard Management Company.  When he returned, he was named Co-CEO and Co-CIO.

It turned out that he and Gross were a bad match, but it would take more than six years for the breakup to occur.

Both were paranoid, in the Andy Grove only-the-paranoid-survive sense of the word, but both were driven to notch personal wins too.  El-Erian had his own flaming emails to match Gross’s, often sending them off from distant lands as he flew the world around visiting clients.  Now there were two alpha males, fighting for position.

The son of a diplomat, El-Erian was the consummate behind-the-scenes operative.  A former Pimco partner is quoted (by name) in the book:

Mohamed operated in a Machiavellian way . . . behind the scenes, usually in unilateral conversations, where he would conspire to bring others into supporting his view that other people in the organization should not be given the responsibility they currently are, or compensation, or role.  He was a champion underminer of people, in a stealth fashion.

The pressures grew within the organization.  People started to pick sides.

Gross had always been distrustful of bureaucrats (a quite common point of view among investment managers).  Childs quotes him as saying to some traders, “I’m Secretariat.  Why would you bet on anyone other than Secretariat?”

Pots of gold

Monstrous paydays were the norm.  For example, one year Gross made around $300 million and El-Erian about $230 million — after so-so performance and notable outflows from Pimco’s flagship product.  And they weren’t the only ones getting rich.

Childs:

Compensation was Pimco’s devil’s bargain.  It was also largely how the firm expressed affection.  Why else would anyone tolerate such a scorching office climate?

The extreme unpleasantness was the cost of fatter paychecks than almost anywhere else, at least at the top — and beneath:  the hope of those future paychecks.

So what if it’s a “crucible of toxicity”?  As Don Draper said in Mad Men, a clip of which has become a widespread Twitter meme, “That’s what the money is for!”

The fall

It was destined to end badly.

The fault lines were lying in wait, not just those between Gross and El-Erian, but all of the ones that had been covered up on the one-way road to success.

There had been tremors before, but an earthquake had never occurred until El-Erian resigned in early 2014.  Gross was out eight months later, gone from the firm he defined.

With the solid reporting and good writing that is featured throughout the book, Childs details the palace intrigue and maneuvering that accompanied the deposition of the king.

The subtitle of the book is “How One Man Made a Market, Built an Empire, and Lost it All,” although in his Wall Street Journal review of it, James Grant suggested that it should be “How One Man Reimagined a Market, Built a Business, Got Rich, and Stayed Rich.”

Each is true in its own way.  Like many investment managers before him, Gross got rich and stayed rich, even after losing his edge.  But he also lost his firm and his spot upon the throne, which were the real treasures he had sought.

~~~

Posting two:  “Hunting for Edges that Others Didn’t See”

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, from The Bond King, sets up this 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 previously noted, 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.

~~~

Posting three:  “Challenges and Quandaries in Manager Research”

In The Bond King, Mary Childs writes that a 2014 article by Greg Zuckerman in the Wall Street Journal

shocked those outside the bond market.  The infighting, Gross’s stringent rules on the trade floor, the crown of thorns?  It was a lot.  The Wall Street banks who covered Pimco knew how tightly wound things were in Newport Beach, as did competitors who’d hear the horror stories or who had interviewed there and run away in terror.  But outside of that, no one had had a clue, until now.

How about those investing with Pimco, those doing due diligence on it?  Did they have a clue?

If your organization has an archival research database that contains notes and reports about Pimco across the years, you should go back and look at them, whether they were internally generated or came from research firms that followed Pimco and offered advice to investors about it.

Can you find any comments about the toxic culture — or the “blame-seeking framework” (to quote Childs) that was at its core — before the WSJ article?  If so, when and why did they show up?  If not, why not?  Are there any concerns expressed in the notes that weren’t put into a formal report?  If so, why weren’t they published for others to read?

Questions for manager analysts

The subtitle on this section indicates that it is for “manager analysts,” but that should be interpreted broadly as anyone, no matter their title or role, who is charged with evaluating investment managers.

The referenced questions appear throughout the rest of this piece, indented and in italics.

Culture

The dominant thematic questions for consideration presented by the book are:

Does the culture of an asset management organization matter to you, or is it the results that count?

What kind of culture produces the best investment performance?

A recent survey found that “despite the widespread marketing jargon with respect to culture, it plays the least important role in manager selection” (of the factors that were studied).  It seems that all managers talk about their wonderful cultures — if you found some old reports in your archives, check out what Pimco said about its own — and manager selectors speak to its importance too.  Is that all for show (on both sides of the table)?

If the benefits of the aggressive moves by Pimco chronicled in the previous posting led to good performance, perhaps the costs of that corrosive environment were worth it.  But managers that trod that path can create an inherent instability that at some point leads to bigger problems.  Pimco has survived but many others with the same mentality have not.

Saint Augustine of Hippo is famously quoted as praying, “Give me chastity and continence, but not yet.”  Investors want the upside of winning in whatever way possible but not the downside — to be on board for the good years but to spot the problems before they become visible to others, show up in the numbers, catch the attention of regulators, or appear in the Wall Street Journal.

In recent years there has been a raft of studies about organizational behavior that promote principles which are often eschewed within investment firms.  Psychological safety?  Emotional intelligence?  Social sensitivity?  (Etc.)

Are asset management organizations different from other kinds of organizations when it comes to the methods for creating a culture that leads to sustainable success?

If so, why, and in what way?

These kinds of simple but important questions should be at the heart of discussions about culture, but they are usually not addressed.  Descriptions of culture, from managers and allocators alike, are typically full of hazy platitudes.

If culture does matter to you:

How do you further your knowledge of the attributes and indicators of organizational culture, in general and specifically for asset managers?

What tactics do you use to crack the narratives that are offered about culture by managers? 

Edges

Looking back, with the benefit of hindsight and years of reporting, Childs was able to provide examples that provided evidence of edges at Pimco.

Everyone says they have smarter people, better networks, and differential processes, but most managers are relatively equivalent to one another.  And performance isn’t proof of an edge, although it may be an indicator.

Key man

Despite Pimco’s heft (it likes to advertise the number of portfolio managers it has), Bill Gross so dominated the firm and the public perception of it that he was the embodiment of so-called key-man risk.

As became evident, that can be a blessing as well as a curse.

How do you weigh the potential pluses and minuses of having someone so singularly important to a firm?

What do you do to sort out the reality of his or her influence/dominance at the firm versus the public perception?

To what degree is your impression of the individual affected by their personality and observed behavior?

(Also, Gross’s move to Janus is a reminder that when a star goes off to another firm they often don’t live up to expectations.  They weren’t alone in making that track record.  Environments are hard to recreate.)

Decision making

According to Childs, “Traders grumbled that the Investment Committee meetings and forums, the deliberations and posturing — it was all theater, because in the end, they just traded what Gross already thought.”  Reality is often different than advertised (there was also a “shadow investment committee” at times).

And, if that’s the case when it is only employees in the room, what do you think happens when outsiders are invited to “see what the process is like”?

In what ways can you break through the theater and the process diagrams to get a sense of how decisions are really made?

Oversight

The head of the Pimco fund board’s governance committee “said the board had learned about the Gross/El-Erian drama when they read about it in the paper, like everyone else.”  He had been on the board for twenty-three years, but after the article he made public comments about Gross’s compensation, his “bullying” management style that had been revealed, and his “mediocre” performance at the time.  (He was off the fund board within three months.)

It was a reminder that mutual fund boards don’t control what happens at management firms; they are separate entities.  And in most cases they only know what they are told by the managers — and they don’t do any independent investigation or analysis of them, except as legally required, which doesn’t cover most of the issues that manager research analysts should care about.

Investors who rely on those boards — or other overseers or gatekeepers — often have misplaced expectations about the quality of reviews that they conduct.

Do you count on any outside entities, such as mutual fund boards, regulators, or investment research firms, to serve as watchdogs on your behalf?  In what ways?

Accolades and attention

Gross has talked about the importance of public relations to his success (including in this podcast).  The “Bond King” appellation was a powerful lever, as was Morningstar naming him the “Fixed Income Manager of the Decade” in 2010, but they were just part of an ocean of recognition and promotion.

It all has an impact, reinforcing consensus views, making it harder to form a contrary opinion and to have others act upon it.  That’s true for others too — like consultants and research firms — who are reluctant to back away from a portfolio manager who has been good to them.

How susceptible to these pressures are you and those who judge your recommendations about managers?

What strategies do you use to avoid the traps involved? 

The process of due diligence

Investors could hear Gross speak at a conference, and perhaps a few would have an opportunity to briefly rub shoulders with him there.  But most due diligence analysts didn’t ever get a chance to sit down with him to ask questions.  In fact, visitors to the Pimco trading room to “see how things worked” were sometimes admonished to not engage with him if he happened by.

As at many other large firms, there were layers of intermediaries who provided the information that was desired.  But, if it came to be that you had the opportunity to interview Gross, what would your questions be?  The power imbalance involved might result in a fawning question or two — or obvious, easy ones that could be dispatched quickly by him.

Now think about what Gross would do if the situation was reversed.  He would ask the hard questions, realizing the softballs that every one else tossed would yield nothing in return.

Many doing due diligence are too cautious with managers, and not just the famous ones.  They are concerned about future access, so they don’t want to ruffle feathers.  It’s not that you want to go in with both guns blazing, but you need to go where others haven’t gone.

If there is pushback, it’s useful to turn the tables and ask them what their own standards of due diligence are, how they would approach the investigative process if they were in your shoes.  That puts things in perspective.

That advice goes beyond your list of questions to the broader menu of tactics that you employ to get information and develop understanding about a manager.  If they squawk about one of your requirements or requests, relate your quest to their own.  Would they advocate for a more lax approach to due diligence?  You have them in somewhat of a box.

How willing are you to be innovative in your approach to manager analysis and in the process of due diligence, so that you are playing a different game than others in order to surface differential information?

What works for you and what doesn’t?

A fertile source

The questions could go on; these are just a few of the ones spawned by The Bond King.  It covers major events in the history of the investment business, paints portraits of the people at the heart of a fabled organization, and prompts consideration of what makes asset management firms special and how they should be analyzed — making it a fertile source for due diligence ideas.

~~~

Posting four:  “Performance Results and Measures of Greatness”

This serves as a coda to previous postings about The Bond King, addressing bottom-line assessments of Bill Gross and Pimco.

Performance

Any discussion of the performance of a fund involves complications, but let’s start with a simple chart of Pimco Total Return since its inception:

The return in the top panel is the relative performance of the institutional shares (PTTRX), which have been in existence the longest.  At the bottom are the total assets across all share classes.

Gross managed the fund from its beginning until that vertical line signaling his departure.  As you can see, the performance and assets were mostly up and to the right.

Some of the zigs and zags in the lines are illuminated by the happenings described in Childs’s book, particularly the strong performance (and growth in assets) coming out of the financial crisis — and the noticeably sharp bout of underperformance during 2011.

That was attributable to a significant, misguided bet against Treasuries. As was his style, Gross had widely promoted it.  But, wrote Childs, “Five months after he made it, Gross’s bold call was publicly, exceptionally wrong.”

Among the complications when considering performance is what the benchmark ought to be.  A long-standing issue with many of the leading bond funds is that they didn’t match up very well with the Bloomberg Aggregate (and its variously-named predecessors), yet it is the standard by which they have been measured.  The funds took on more risk than the index — by overweighting certain areas and investing in vehicles that weren’t in the index — which paid off given the bond-friendly environment that lasted for decades.

Notions of alpha

In 2019, Richard Dewey and Aaron Brown published a paper entitled “Bill Gross’ Alpha: The King Versus the Oracle.”  The “oracle” referenced in the subtitle was Warren Buffett.

The authors explained that determining the alpha delivered by Gross is different than doing so for an equity portfolio, because “fixed-income securities have much higher correlations with each other than equities, [making] alpha 4.5 times as hard to measure for Gross than Buffett.”

Using the Bloomberg Credit Index rather than the Aggregate, they found that Total Return “generated 1.33% per year of alpha, with a t-statistic of 3.76” during the time Gross managed it, although analyses by others show less robust results.

The paper is worth reading for its general points about the difficulties of judging alpha when it comes to bond portfolios.  For starters, the publicly-available information on portfolio holdings is usually incomplete.  Furthermore, the attributes of an index of bonds change over time in ways that stock indexes don’t — and the prices used (for an index and for a portfolio to be judged against it) “necessarily contain a mix of opinion and observation of arms-length transactions.”

Gross to Janus

After leaving Pimco just before he was pushed out, Gross moved to Janus to manage an unconstrained fund that had been started just four months before.  Here’s that fund (shown in a similar fashion to the chart above; it is now named the Janus Henderson Absolute Return Income Opportunities Fund):

The good performance did not carry over to his new firm, at least in terms of this benchmark comparison.  Gross did attract some assets, although the Wall Street Journal reported that half of the $1.4 billion of assets in the fund after Gross had been at the helm for a year were his own.  The underperformance of the fund in 2018 triggered strong outflows, and Gross retired for good in February of 2019.

The Total Return ETF

It was big news in 2012 when Pimco started an ETF with the same strategy as its widely-popular Total Return mutual fund.  (The original ticker, TRXT, was changed to the more iconic BOND after a month, and the Total Return name was changed to Active Bond in 2017.)  An interesting part of the book details the desire to have the ETF come out of the gate quickly.

This chart shows how successful the tactics (mentioned earlier in this series) were, by plotting the relative performance versus AGG (its natural competitor as the ETF that tracks its index) and the two main classes of the mutual fund.  After the sharp early rise, BOND has had minor changes versus each of them from then until now.

Gross in his own words

The monthly “Investment Outlook” pieces by Gross that drew so much attention from market participants have been removed by Pimco and Janus, but he has made many of them available online.  He has also written a book, which he rushed out shortly before The Bond King was published.

An article, “Consistent Alpha Generation through Structure,” was written by Gross for the Financial Analysts Journal in 2005.  While the phrase “structural alpha” didn’t appear within it, he detailed some of the elements of that concept.

They included “the use of financial futures or future-related investments and the successful placement of the residual cash into higher-yielding, slightly longer-dated investments,” which could add “20 bps a year without even breathing hard.”  Additionally, there were various categories of “selling of unlevered volatility,” including a greater use of mortgages (capturing the mispricing of the prepayment options embedded within them; 10 bps a year), options on Treasury futures and swaps (5-10 bps), and overweighting the front end of the yield curve versus an index (the value added from that was not specified).

At the root of those structural opportunities was that there are market participants who,

because of their inherent character or the role they play, provide profits to structural investors taking the other side of the bet.

Measures of greatness

Gross built Pimco and managed its lead portfolio during an unusual time in the markets.  The environment for bonds was benign, except early on in Gross’s career, before the Total Return Fund came into existence.  So was he a product of the times or a unique talent?

Both.

An important reminder, however, is that despite the fact that Gross is seen as the owner of the track record, the returns were the product of an organization, not one person.  The results at Janus may be evidence of what happens when you take the man out of the ecosystem.

That said, it in no way diminishes his accomplishments.  In their paper cited earlier, Richard Dewey and Aaron Brown said this of Gross:

He acquired investors and leverage, he ran his fund efficiently, he stuck with his high-risk principles even when they were going through bad periods, and he communicated so that his investors not only stuck with him, but gave him the funds to build the largest bond fund in the world.

Along the way, he and his firm changed how markets and the investment industry were structured, as others adopted the methods they pioneered.

That’s quite a legacy.  The Bond King is an important book, because it goes behind the scenes at Pimco, revealing plenty of drama even as it prompts questions for the asset managers of tomorrow (and those who evaluate them) regarding the best ways to build portfolios and organizations that succeed.