FUNDS


The Bond Kings Spice up Their Menu

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."

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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.

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."

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.


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