Understanding Pimco's Rough 2013

Bill Gross may be the best bond fund manager on the planet—just not in 2013. For Gross and his comrades at Pimco funds, it was a year to forget. More than half of the firm’s 88 funds ranked in the bottom half of their peer groups last year. Flagship Pimco Total Return (PTTDX), which Gross has run since 1987, finished in the bottom third of all taxable intermediate-term bond funds.

Other Pimco funds struggled even more: Unconstrained Bond (PUBDX), a flexible, go-anywhere debt fund, trailed 85% of all nontraditional bond funds. And Commodity Real Return Strategy (PCRDX), which invests in commodity futures and backs them with inflation-protected bonds and other debt, landed in the bottom 10% of its category.

What happened?

A big selloff following suggestions by the Federal Reserve last May that it might soon trim its aggressive bond-buying program apparently caught Pimco by surprise. Many Pimco funds, including Total Return and Unconstrained Bond, had big bets on two of the worst-hit sectors, emerging-markets debt and Treasury inflation-protected securities. (Emerging markets hurt many of Pimco’s flexible funds, including two All Asset funds run by an outside adviser. Pimco All Asset All Authority (PAUDX) had about 30% of its assets invested in emerging-markets stocks, bonds and currencies all year.)

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One reason so many Pimco funds stumbled last year stems from the way the firm operates. An Öberinvestment committee makes big-picture calls on the economy and interest rates for the company. Those calls then drive the strategy of many Pimco portfolios. When the calls are good, the firm’s funds do well. When they’re bad, they don’t.

An exodus by panicked fund investors added to Pimco’s woes. “There’s been unprecedented selling” of Pimco funds since May, says Doug Hodge, the firm’s chief operating officer. Case in point: Total Return, until recently the country’s biggest mutual fund. Since the beginning of May, $39 billion more exited the fund than came into it. (Pimco also manages Harbor Bond, a member of the Kiplinger 25, in a style similar to that of Total Return.)

Pimco has changed course quickly after previous stumbles. This time around, it loaded up on Treasuries during the spring selloff, taking advantage of lower prices (and higher yields). And it scaled back its exposure to emerging markets. Total Return’s holdings in developing-markets debt dropped from 7% of assets in January 2013 to 4% by September. But the firm hasn’t changed its view on TIPS because it considers inflation a long-term risk, says Bob Greer, who leads Pimco’s inflation-protected bond team.

Meanwhile, Gross has taken over at Unconstrained Bond while the current manager takes a sabbatical. And Mohamed El-Erian, Pimco’s co-chief investment officer with Gross, will expand his role at Global Multi-Asset (PGMDX). He’s been the lead manager since its 2008 launch, guiding its positioning in stocks, bonds, commodities and currencies. But the fund was truly awful last year, losing 8.9%, so El-Erian will become more involved in security selection.

It would be foolish to count Pimco out for poor short-term performance. But the lesson here may be that it pays to diversify your bond funds among several money-management firms, especially when a firm’s funds rely so heavily on direction from the top.