The Wall Street Journal on February 25th published a story about December’s messy corporate divorce between Bill Gross and Mohamed El-Erian as Co-Chief Investment Officers at Pacific Investment Management Company (PIMCO), the world’s largest bond fund with almost $2 trillion in assets.
The article focused on the prickly personality of Gross and foul-language complaints by El-Erian during a period of stress last summer when the firm was suffering market losses and clients were withdrawing billions. Despite a carefully crafted image of a traditional conservative bond manager for “serious” money, PIMCO has magnified returns by making trillions of dollars in high-risk derivatives bets. From personal experience and the firm’s latest financial filings, I estimate PIMCO’s leveraged derivatives empire could eventually crash and cause massive pain.
In December 2006, I was sworn in as the elected Treasurer of Orange County, California. Twelve years earlier, I helped Barron‘s Editor Alan Abelson write the exposé on Orange County’s secret use of leveraged derivatives to triple the interest return from its $6 billion short-term investment fund. The article revealed huge hidden losses that forced the County to file the largest municipal bankruptcy in the history of America on the same day.
From 1996-1998, I assisted in the financial restructuring of the OC’s public pension plan. Warren Buffett would later describe derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” After devastating losses of $1.7 billion and criminal prosecutions, in my wildest imagination I could not imagine Orange County would ever be invested in derivatives again.
A duty of the Treasurer is to serve as one of nine members of the Orange County Employer’s Retirement System (OCERS) that manages the county’s $9 billion defined-benefit pension plan. As an experienced investor, I asked for the most recent month’s detailed print-out of the pension’s transactions. What I discovered was PIMCO, as our money manager, had leveraged the $900 million in supposedly “core” bonds by almost 25 times through the purchase of $22.3 billion of derivatives.
The Orange County Board of Supervisors, at my April 3, 2007 request, hired Strategic Investment Solutions, Inc. (SIS) to meet with OCERS pension staff to review money managers utilizing leverage, derivatives, and currency futures; provide comparison of the overall risk exposure; and report analysis, findings, and recommendations.
The SIS report found that OCERS had signed PIMCO’s investment agreement that “No transactions are specifically prohibited. PIMCO has full discretion to use any type of derivatives, leverage and shorting.” Furthermore, “investments in common stock and equity futures are prohibited; other than this, PIMCO can invest in just about any type of security or derivative. No transaction types are explicitly prohibited.” In comparison to other pension investments, “PIMCO has by far the most complex portfolio.” SIS stated in summary, “As it now stands, the ‘Portfolio Summary’ and ‘Derivatives Summary’ reports do not adequately portray what’s really going on ‘underneath the hood.'”
Based on bad publicity and SIS recommendations that “risks that were accepted with a different economic and investment outlook should be reevaluated,” PIMCO cut derivative use in the Orange County public pension plan by 90%.
However, analysis of the Third Quarter Report for PIMCO Total Return, the $230 billion bond mutual fund popular for individual savings and retirement accounts, reveals, despite PIMCO literature that the firm “seeks maximum total return, consistent with preservation of capital and prudent investment management,” the firm heavily invests in derivatives. PIMCO claims at least 65% of its “total assets” are invested in a diversified portfolio of bonds but acknowledges use of derivatives such as options, futures contracts, or swap agreements and 10% of assets in junk bonds. Derivatives may be only 25% of Total Return assets, but they are bought for a fraction which is usually less than 5% of the underlying asset. Consequently, derivatives may create 20 times leverage and offer unlimited upside and downside risk.
According to the Morningstar Top Holdings snapshot, about three quarters of PIMCO derivatives were bets on European currency financial futures, and the balance was on U.S. dollar futures. Some of PIMCO holdings have a “negative cash position” that usually represents short selling – short sale being a speculative investment that profits when prices fall. The Total Fund portfolio looks similar to a leveraged hedge fund portfolio. PIMCO derivatives seem all about “maximum return” and not very much about “preservation of capital and prudent investment management.”
PIMCO Total Return fund reported investment performance that beat 96% of the money managers that they compete with for clients over the past ten years. Mohamed El-Erian collaborated with PIMCO’s founder Bill Gross during this period, first as a member of the Board of Directors and then as full-time Co-Chief-Investment-Officer from 2007. The returns by Gross and El-Erian received great adulation in the press, and huge amounts of investor cash poured into the firm.
Yet with the significant influence of derivatives influencing any fund’s overall performance, every now and then even a mastermind will be devastated by being overexposed to the wrong bet at the wrong time.
The WSJ highlighted a very stressful moment last June on PIMCO’s trading floor, when Mohamed El-Erian “squared off in front of more than a dozen colleagues amid disagreements about Mr. Gross’s conduct.” Gross snarled he had a 41-year track record and challenged El-Erian’s contribution to PIMCO. El-Erian snapped back, “I’m tired of cleaning up your s–.”
At the time of the incident, the bond market was under selling pressure, and PIMCO losses were causing clients to yank billions of dollars from the firm. Very few clients have any clue regarding the massive amount of derivative risk PIMCO takes with their money. A Journal source stated, “Pimco needs to avoid becoming an upside-down pyramid balanced only on Bill Gross.” With trillions of dollars of leveraged derivative risk “underneath the hood,” PIMCO already seems to be an upside-down pyramid.
The author welcomes feedback and can be contacted at chriss@chrissstreetandcompany.com
Chriss Street will teach microeconomic at UC, Irvine this spring. ECON X419.34 (3 units): March 31 – June 8, 2014 Where: ONLINE Fee: $630 Reg #: 00026 (Spring 2014) Call Student Services at (949) 824-5414 or visit http://unex.uci.edu/courses to enroll!
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