What Really Happened at PIMCO

As I mentioned over the weekend, the month of September ended with two dramatically different exits: The Hollywood ending of Yankee Captain Derek Jeter's Hall of Fame 20-year career, and the acrimonious departure of Bill Gross from PIMCO, the firm he founded 43 years ago.

The departure of the two could not have been in starker contrast.

More importantly, as investors, we can learn a great deal by taking a moment to explore why Gross took the extraordinary step of leaving the institution with which he is synonymous.

It's About Gross' Investment Legacy, Not His Management Style

Derek Jeter is a rare breed in today's world of sports. He played two decades for the same team with class and humility, was a great teammate and leader, and a wonderful role model.

Bill Gross is also a rare breed, as evidenced by his market-beating returns and enormous success. However Mr. Gross was also known to be extremely demanding and difficult to work with; even he would likely admit he could have been a better teammate and leader. But he remains a thought leader in the investment community and will always be known as the founder of one of the world's formidable investment firms.

Highly accomplished people are often difficult to work with, particularly in high-stress professions where the stakes are high or large sums of money are involved. This is true in business, politics, the entertainment industry, and the military.

I have worked for and managed money for some of the most accomplished and demanding individuals in the investment business during my career. I learned early on that this is not a business for sensitive types. But I also know that I have been taught by the best and wouldn't have had it any other way. Managing money is a tough business. Managing hundreds of billions of dollars places an unimaginable burden on a person. Before people pile on Mr. Gross, let them walk a mile in his shoes. Nobody worked harder to deliver great returns for his investors over the last four decades.

But eventually the stress and strain takes its toll, and the demands can become unmanageable...

Gross' "Minsky Moment"

There is no doubt that Mr. Gross also truly is in a class by himself as an investor. He created total return fixed income investing in the 1970s and managed more money than any individual in the history of the world for over four decades. And despite recent setbacks (which in the scheme of things are truly minor), he continues to claim one of the best track records in the history of investing.

Over the last 15 years ending August 31, 2014, his PIMCO Total Return Fund (MUTF: PTTRX) earned an annualized return of 6.9%, beating 96% of its peers. Since its inception in May 1987, PTTRX has earned an average return of 7.9% while the Barclays U.S. Aggregate Bond Index averaged 6.8% annually over the same period.

In 2008, when many investors got their clocks cleaned, PTTRX produced a positive return of +4.8% and beat most of its peers, a performance of which few investors in any asset class can boast. PTTRX generated that return while maneuvering an enormous sum of money, which makes the feat even more remarkable. Mr. Gross himself acknowledged that over the course of his career he benefitted from investing during the epic bull market in bonds that began during the years when Paul Volcker ran the Federal Reserve and tamed inflation. But his outperformance illustrates that he did much more than benefit. Now that this bull market has ended, he has the opportunity to bring his unparalleled expertise to bear on a more challenging environment. I wouldn't bet against him.

While praising Mr. Gross for his past accomplishments, it is also fair to suggest that he began to stretch for returns in recent months as he struggled to navigate the Battleship PTTRX through the shoals of increasingly unforgiving fixed income markets...

When the returns of PTTRX began to lag in 2013, he engaged in a series of moves to improve performance that failed to work. Very recently, he extended the duration of the PTTAX portfolio from 5.0 to 5.7 years, sold most of his Treasuries and replaced them with derivatives (Treasury futures), introducing more counterparty risk into the portfolio, and began buying peripheral European sovereign debt.

As of September 15, the fund was trailing 2/3 of its peers and had earned 1.6% year-to-date. Mr. Gross's recent strategy was driven by PIMCO's thesis that the economy is entering a period it describes as the "new neutral" which will be characterized by below-trend growth and slower-than-expected interest rate increases. While I concur with this thesis, I disagree that the right response is to increase leverage (through derivatives or otherwise) and wade into riskier debt such as European peripherals trading at unsustainably low yields.

Mr. Gross's recent moves are the type of behavior that the great economist Hyman Minsky warned about when he developed his "financial instability hypothesis" that argues that stability breeds instability. As investors spend more time in a stable market environment of the type that has persisted over the past few years, they tend to take more risk.

This appears to be precisely what Mr. Gross was doing prior to his departure. Mr. Gross's former colleague, Paul McCulley, coined the term "Minsky moment" to describe what occurred in the 2008 financial crisis when stability tipped over into instability. Perhaps someone should hand out a copy of Professor Minsky's famous essay at the next meeting of PIMCO's credit committee. With global debt reaching ever more epic levels, this is precisely the time investors should be reducing rather than increasing risk.

With Gross' departure comes risk, one that we may not want to take, and we need to think in terms of what's in store for PIMCO in the near future....

The Near Future for PIMCO

Investors are asking what they should do with their investments in PIMCO-managed funds and ETFs. There is no question that Mr. Gross's departure was handled poorly both by him and the company. Investors were caught flat-footed at the abrupt resignation of the manager of the world's largest bond fund - and that is inexcusable.

Reports that he was about to be summarily fired and resigned in order to avoid such an ignominious end suggest that management at the firm failed. Such failure is particularly inexcusable in view of PIMCO's size and systemic market importance. PIMCO retains a strong group of investment professionals, but institutions and wealth managers are fiduciaries with a low tolerance for serious management lapses.

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Accordingly, and as we might expect, PIMCO is already seeing large outflows from its funds and ETFs that may accelerate over time as clients come to realize just how poorly PIMCO managed this situation. The question for investors is less about the firm's expertise in managing money, which should not be questioned, but about whether its mishandling of the management transition was serious enough to lead one to want to move elsewhere.

PIMCO remains a formidable firm... But it has some damage control ahead of it in the short-term.