By Brooke Southall | RIABiz
Brooke’s Note: Reading Bill Gross’s latest blog entry, my eyes lit up when he made a very pointed allegation about his old employer, PIMCO. In my reading, and that of others I contacted, the Janus bond manager is saying that PIMCO uses derivatives in a way that does more harm than good in its Total Return Fund. Gross doesn’t say how he knows this. Is it a practice he was either privy to or the author of in his time there? Who knows. Either way I wanted to know if PIMCO agreed with his characterization of what it is purportedly doing. As is its habit, PIMCO did not respond to my queries. I also wanted to know if Bill Gross thought I was reading his message right, but his spokeswoman at Janus Capital also declined to respond to an emailed request. It does seem like a dicey matter for either side to elaborate on — making heavy use of options to solve the liquidity issues at the expense of creating underlying instability. No outside experts wanted to go on the record discussing this matter either. All, that is, except one person who really knows his stuff: Jim Dowd. He has no direct knowledge of Gross’s thinking or PIMCO’s but was willing to share his perspective to shine a light on what Gross seems to be saying and what we should make of it. See: Dear Bill Gross, Please stop crowdsourcing emotional support and making open-ended calls of doom.
PIMCO is heating up an already hot liquidity issue in the mutual fund markets by using a strategy with potentially disastrous side effects, according to Bill Gross, manager of the Janus Unconstrained Bond Fund at Janus Capital Group Inc. See: Why I respectfully reject the harsh take on unconstrained bond funds expressed by Google and LPL co-authors.
In the June 30 entry of his monthly online column entitled It Never Rains in California, Gross employs a cascade of water-related metaphors to make the case that Pacific Investment Management Co. is using derivatives as a short-term fix to offset massive redemptions in its Total Return Fund. Gross addressed the subject in the context of long-held liquidity fears related to mutual funds and the ways in which fund owners as a group — and, ahem, PIMCO chief executive Doug Hodge in particular — have sought to assuage such concerns.
The outflows at the PIMCO fund are a partial result of Gross’s contentious exit from the firm he founded a year ago. See: At Morningstar, PIMCO CIO and CEO preach collective manager brainpower but individual manager accountability as post-Bill Gross formula.
In his entry, Gross rebuts the idea that PIMCO’s success with its mega-redemptions should be taken as solace for people fearing a liquidity crisis down the road. He posits that in fact PIMCO’s current course could result in an intensifying of redemptions, which could, in turn, spin out of control with ever-greater, leverage-fueled velocity.
“The PIMCO example is not a good one to use to prove the current liquidity of mutual funds, ETFs, and even index funds,” Gross writes in his article. “Hodge himself admitted to internal proprietary 'liquidity’ provisions, adding that it used derivatives for exposures 'to support cash buffers and inflows.’” See: PIMCO is 'probably healthier’ without Bill Gross and the outflow bloodbath is likely near its end, Morningstar says.
Gross continues, writing: “The fact is that derivatives on a systemic basis represent increased leverage and therefore increased risk — presenting possible exit and liquidity problems in future months and years.”
Neither Janus nor PIMCO responded to requests for clarification or interpretation of Gross’s remarks.
Derivatives are securities whose price moves based on the value of underlying assets. The derivative itself is a bet between parties on the direction that a security is going. Although derivatives — puts, calls, futures and other options — are de facto legalized gambling, they are also instruments of responsible investing in that they can be used to hedge positions, thus lessening risk. See: Why unconstrained bond fund skepticism is justified (think 2008, not 2013) and why RIAs should say: None of the above.
Jim Dowd: I don’t think he’s being vindictive, but I think he enjoys poking people in the eye
Gross is on solid enough theoretical ground in raising this liquidity specter in relation to PIMCO, according to Jim Dowd, managing director of North Capital Inc. of San Francisco.
“You have less visibility into what’s going on and it can accelerate the decline.”
Dowd, the former head of the hedge fund investment team at Bear Stearns Asset Management, adds that this disaster scenario is all too familiar as his now-defunct company fell victim to manic fears about the “de-leveraging on the derivatives side. There was no possible way you could sell the assets.”
Having said that, Dowd adds that he can’t imagine a trigger that would set off the kind of PIMCO-centric run that Gross is envisioning.
“It’s not like with a hedge fund where everyone thinks the manager is a fraud and everyone wants to get out all at once,” he says. See: Chasing bad performance: Why investors can’t get enough of those increasingly lame hedge funds.
And yet, in his column Gross suggests that hedge funds could actually have an edge over mutual funds and ETFs in such a situation.
“While private equity and hedge funds have built-in 'gates’ to prevent an overnight exit, mutual funds and ETFs do not,” he writes. “That an ETF can satisfy redemption with underlying bonds or shares, only raises the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances.” See: How ETFs have been oversold when it comes to flexibility, lower costs and tax efficiency.
Dowd counters that Gross is leaving out key information in conjuring up such a grim scene — namely what exactly PIMCO is doing with its derivatives and how liquid its assets are.
PIMCO is very likely leveraging liquid assets like U.S. treasuries, according to Dowd, which likely gives the firm ample wiggle room with which avoid a liquidity crisis. Indeed, he says, big managers of passive indexes like Vanguard Group would face the bigger challenges in a run on funds in that it must adhere to a strict indexing formula whereas PIMCO has some discretion about its holdings. See: Vanguard Group, set to gather $300 billion in 2015, is crushing it on every level but could it succumb to its own success?.
In his column, Gross goes on at length about the faulty foundation on which the mutual fund system is built.
“Shadow banking structures — unlike cash securities — require counterparty relationships that require more and more margin if prices should decline. That is why PIMCO’s safe haven claim of their use of derivatives is so counterintuitive.” See: With kid gloves and after great patience, Morningstar yanks gold-level rating on PIMCO Total Return Fund and predicts possible exit of 'tens of billions’ in assets.
Of course, it is well documented that Gross has a chip on his shoulder when it comes to his former employer — even by Gross’s accounting.
“Down the street from PIMCO, I must openly acknowledge that helping to turn Janus into one of these 'too important’ companies is one of my objectives, as it is for CEO Dick Weil,” he writes. “But that day lies ahead of us.” See: How Janus CEO Richard Weil’s Bill Gross hire completes the PIMCO-ization of the Denver equity shop.
So is Gross simply dumping on PIMCO gratuitously?
Dowd thinks not.
“I don’t think he’s being vindictive,” he says. “But I think he enjoys poking people in the eye sometimes.” See: Just what damage was done — or not — by Bill Gross ranting in shades.