Mohamed El-Erian is leading Pimco's move into stocks. Photograph by Tim Rue/Corbis
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.
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