Pimco is getting ready to make a big move into stocks. By Elizabeth Leary, Contributing Editor August 31, 2009 There's little about the trading room at Pimco's headquarters, in Newport Beach, Cal., that resembles the popular image of a Wall Street trading floor. Yes, the rows of traders, each glued to three or more computer displays, and an enormous screen filled with market data on one wall give away the room's purpose. But no one is shouting prices, jumping on desks or showing an iota of emotion as the market moves one way or the other. Instead, the room hums with a hushed focus. The near-silence helps to keep any market panic or euphoria from disrupting the occupants' Zen-like concentration, says Pimco spokesman Mark Porterfield. Indeed, the traders' only distraction is the view of Newport Bay through the room's picture windows.At the center of the floor you'll find the cerebrum of the operation. Mohamed El-Erian, chief executive and co-chief investment officer, and Bill Gross, co-founder and co-chief investment officer, supervise the corporate body not from swank corner offices, but from the thick of the operation. The pair sit side by side behind U-shaped desks, their backs to the windows, a left and right brain watching over the room. Of the two, Gross certainly represents the right hemisphere: The debonair philatelist has picked up investing secrets at the blackjack table and has occasionally been known to strike upon an insight while standing on his head in yoga class. And El-Erian is the left: The economic theoretician, having split most of his adult life between academia and the International Monetary Fund, peppers his sentences with phrases such as "forward-looking" and "risk factors." Advertisement At the top of its game Pimco -- a unit of German financial-services giant Allianz -- and its top minds are in high demand. Thanks to Pimco's reputation for thoughtful reasoning and prescient market calls, El-Erian and Gross are regulars on everything from CNBC broadcasts to Treasury Department conference calls. And Pimco is taking advantage of the glowing public opinion it enjoys to expand. The firm is hiring new managers and contemplating launching new stock funds. All of this is part of management's dream to be not just bond kings, but royalty in all regions of the market. The firm's reputation rests largely on its flagship mutual fund, Pimco Total Return, which bears the public record of how well the firm's calls have translated into investor results. From the fund's inception in 1987 through June 30, its institutional-class shares, which have the longest performance history, returned 8.3% annualized, compared with 7.2% a year for the Barclays Aggregate Bond index. In the bond world, a one-percentage-point edge is an ocean of difference. Pimco's already-glowing reputation has shined all the brighter for its brilliant performance through the current financial crisis. Over the past year through June 30, Total Return gained 9.3%, clobbering the average intermediate-bond fund by nearly eight percentage points. Investors poured $21 billion into the fund over the past year (more than they did into any other single fund), making Total Return the largest mutual fund in the world, with $159 billion in assets. But for all the media attention they receive, Pimco's top two seers depend on a whole cast of bright characters. Chief among them: the other six members of Pimco's investment committee -- the elite decision-making body that determines the strategies of Pimco's 48 funds. Four times a week the group assembles for a three-hour mind meld over a casual lunch. Stop in on a given day and you might find them trying to channel Federal Reserve chairman Ben Bernanke's thoughts on inflation or puzzling over the outlook for market volatility. CNBC runs silently on a TV screen in a corner -- un-muted only when one member steps out of the room for a quick appearance on Closing Bell. Advertisement Although the committee has the final word on big decisions, it keeps an open mind to dissenting views. Take the evolution of Pimco's perspective on the housing bubble. In March 2005 -- more than a year before home prices peaked -- Scott Simon, the firm's top brain on mortgages, told the committee that he'd soured on housing. He argued that home prices would fall in 2007, the first yearly drop since the Great Depression, and would continue to do so until 2010. "Initially, they thought this was kind of ludicrous -- until I laid out my case," says Simon. "Then we decided to systematize how we looked at the issue." Good calls, bad calls One research team dived into the loosey-goosey mortgages that continued to pump air into the housing bubble. Another pored over the history of home prices and learned to interpret the various price, sales and construction data churned out monthly. And Gross had the idea to send analysts to 20 major cities to gather evidence by posing as home buyers. Recalls Simon: "One guy went to Las Vegas, and when he asked his cab driver about real estate, the driver bragged about the four condos he owned as investments. Our analyst came back and said, 'If we're not at the top yet, we will be soon.'" Understanding the magnitude of the coming housing catastrophe prompted the moves that made 2008 such a triumphant year for Pimco. In particular, it helped the firm anticipate the government's takeover of mortgage giants Fannie Mae and Freddie Mac -- the call that Gross ranks as the best of his career. To steady the economy, the investment committee had concluded, the U.S. government would need not only to drop interest rates to rock bottom, but also to step in with some fat checks. "And then the obvious question became: Where would it write the check first?" Gross says. "Because housing was the major problem, we thought that would be a logical point for it to enter." Advertisement So Total Return, and all other Pimco funds with the leeway to do so, loaded up on battered mortgage-backed securities issued by Fannie and Freddie, betting that the government would effectively have to guarantee those securities. On the day Uncle Sam placed Fannie Mae and Freddie Mac into conservatorship, Total Return gained $1.7 billion, or 1.3%. That one call, Gross says, earned Pimco clients at least $20 billion, maybe twice that. Pimco doesn't brag so much about its boneheaded calls, of course. And when you scrutinize the record, they tally a dime a dozen. In recent memory, those have included holding on to Lehman Brothers' debt until the bitter end; getting enmeshed in last year's chaos in the auction-rate securities market (and having to delay dividend payments to holders of some closed-end funds); and betting last year in some of its municipal-bond funds that Treasury-bond prices would fall, when in fact they did the opposite. A recent study of predictions made by Paul McCulley, Pimco's resident Fed watcher, over the past decade shows a history of being wrong more often than right. So how has Pimco wound up on top of the heap time and time again? It knows how to scale its bets. "We only make bets when we think we have an edge," McCulley says. He explains that Pimco will place a mammoth bet, like the one on Fannie and Freddie, only when the team is pounding-the-table-certain not only that its view is correct, but also that the rest of the market disagrees with its view. The less of a table pounder, the smaller a bet Pimco managers will make. Today, the firm is winding down its bet on agency mortgages as the Fed nears the end of its planned purchases of mortgage-backed securities. McCulley says the firm doesn't have any table pounders ready to replace the mortgages, although Gross, in Total Return, has been slowly buying high-quality corporate bonds as he sells the fund's mortgage-backed securities. Advertisement But Gross is debating making a bet on commercial mortgages -- an area where Simon says more carnage is coming and where Gross thinks the government may eventually have to intervene. While exercising recently, Gross says, he came up with the idea of dispatching analysts to inspect the properties underlying the pools of loans that compose commercial mortgage-backed securities. "It makes the same logical sense to send a team of people out to inspect the shopping centers and malls in these various pools, and see if they're empty or full," he says. Had you clicked on the home page of Pimco.com some months ago, you would have been greeted by the company motto: "Pimco: The Authority on Bonds." The motto hasn't changed, spokesman Porterfield says, but the Web site has. Now, visitors meet with an introductory page proclaiming Pimco's mission: "Manage Risk. Deliver Returns. Repeat." The line bears the unmistakable mark of El-Erian, but the subtle change points to larger forces at work in the firm's focus. El-Erian explains that Pimco is working on "a multiyear effort to evolve into an even more complete provider of global investment solutions for our clients." In other words, Pimco isn't content to be pigeonholed into bonds anymore. Expanding product line Expect to see Pimco introduce more stock, or quasi-stock, mutual funds. "We're currently interviewing stock-fund managers from various firms -- looking to start from square one with a new product and apply our philosophy to new areas," Gross says. The firm won't say whether it plans to start offering funds for which managers buy stocks, a move that would mark a profound shift. "I would be nervous if Pimco hired managers" to pick stocks, says Morningstar analyst Lawrence Jones. "That would be departing from their long-standing traditions and approaches." El-Erian says the new stock funds would indeed differ from existing Pimco stock funds, which purchase options and futures contracts on stock indexes but stash the bulk of their assets in bonds. You can also expect to see more hedge fund-like mutual funds on Pimco's roster. Many of its funds, including Total Return, already dabble in derivatives, such as interest-rate swaps and futures. But a new strategy of using derivatives to insure funds against steep losses is at the core of the firm's new direction. "It's exactly the same as buying car insurance," El-Erian says. Managers set a deductible -- representing a maximum loss of, say, 15% -- and purchase derivatives that will kick in to prevent losses beyond that point. "If you go with a lower deductible, you'll pay a higher premium," in the form of the costs of the hedges, and vice versa. If Total Return was the reputation-bearer of the old, bond-focused Pimco, then Global Multi-Asset may assume the mantle for the new, cosmopolitan Pimco. The fund, launched in October 2008, gives El-Erian a chance to put into practice his portfolio-insurance ideas, as well as the allocation recommendations from his book When Markets Collide. El-Erian has come up with what he thinks will be ideal asset allocations for the new world order as the U.S. takes a back seat to emerging markets. He boldly recommends, among other things, allocating only 15% of assets to U.S. stocks and investing 11% in commodities. Because of its short history, it's too early to pass judgment on the fund. This is not to say that El-Erian, who rejoined Pimco as co-CEO in 2008, is the sole promoter of the changes. Gross speaks to the new direction when he talks about his long-term vision for Pimco -- to be "not just the best bond manager, but the best investment manager in the world." Both men would tell you that new strategies simply represent the evolution of a firm that has produced outstanding results for bond investors for nearly four decades. But you do wonder whether the team will be as good at translating its new intellectual pursuits into cold, hard returns as it has been at placing smart bets on markets and sectors. Gross would be the first to question whether the firm he has nurtured for 38 years will be able to wow investors indefinitely. He recalls: "After my first five years in the bond department at Pacific Mutual [Pimco's former parent], the chairman came to me and said, 'Bill, it's been a great five years, but can you do it for another five?' I said, 'I'm not sure; we'll have to see.' And after ten years he came to me again and we had the same conversation." Now, says Gross, "it's been a great 35 years. But check with me in another 35."