Posted by jasonzweig on Oct 4, 2014 in Blog, Posts |

image credit: Petrus Christus, “A Goldsmith in His Shop,” The Metropolitan Museum of Art, http://www.metmuseum.org/collection/the-collection-online/search/459052

By Jason Zweig

1:00 pm ET  Oct. 1, 2014

From the moment Bill Gross quit last week, the investing world has been speculating on how much money might flee his Pimco Total Return Fund, the world’s largest bond fund. Would there be a mutual-fund equivalent of a run on the bank? Would Pacific Investment Management Co. be able to meet withdrawal requests without roiling markets as it sold assets to raise cash?

The odds that a mass investor exodus will shake markets are small. But the departure of Mr. Gross – Pimco’s co-founder and investing mastermind – is the biggest challenge the firm has confronted since it opened its doors in 1971. And it raises some interesting questions, especially for large investors who might seek to pull all their money out at once.

Cash has already started flowing out of Total Return, evidently on a bet that returns will suffer without the “Bond King” at the helm. Roughly $10 billion left the fund on Friday, The Wall Street Journal reported on Monday. That barely amounts to petty cash at the $220 billion fund, but analysts have predicted that hundreds of billions of dollars could flee Pimco firmwide in the wake of Mr. Gross’s departure.

BrightScope, a La Jolla, Calif.-based firm that analyzes retirement plans, estimates that 28,000 401(k) and other employee savings accounts have $88 billion invested in Pimco Total Return. The money in 401(k) plans is dispersed across small accounts held by many investors who are notoriously “sticky,” or slow to take action. The plan sponsors who oversee retirement accounts tend to move sluggishly as well.

The bulk of Total Return money comes from other sources, mostly pension and other institutions, as well as “wrap accounts” and other large pools of money controlled through brokerage firms and financial advisers.

Financial advisers and even larger institutional investors control tens or hundreds of millions of dollars apiece — and some of them chase performance like dogs chase cars.

Pimco executives are in a race to persuade brokerages like Merrill Lynch and Morgan Stanley not to encourage their advisers to dump the firm’s funds, the Journal has reported.

In a 1948 essay, sociologist Robert K. Merton pointed out that self-fulfilling prophecies can best be prevented with “deliberate institutional controls” — as when the introduction of deposit insurance in 1933 effectively brought bank runs to a halt.

There is a deliberate institutional control in this case. One of Pimco’s regulatory disclosures states that the firm “will normally redeem all shares for cash” but “in unusual circumstances” may pay large redeeming shareholders with the fund’s securities instead.

Bottom line: If you sell more than $250,000 worth of the fund, Pimco doesn’t have to redeem your shares with cash. It might instead give you the underlying securities in the portfolio.

During the financial crisis, more than one hedge fund did resort to this step, known as “payment in kind,” when illiquid assets couldn’t be sold quickly to meet redemption requests. Mutual-fund companies, too, have used it selectively in the past; there is no better way to forestall a potential “run on the bank.”

A Pimco spokesman didn’t respond to a request for comment about whether the firm may need to invoke the right to redeem selling shareholders “in kind.”

On Monday, approximately 12.5% of total assets in a related exchange-traded fund, Pimco Total Return ETF, left in a single day, according to ETF.com and TrimTabs Investment Research. But the exodus was orderly and didn’t appear to cause a sharp selloff in the underlying holdings — or a cascade of panic. This $3.6 billion ETF, which had also been managed by Mr. Gross, is modeled after the original Total Return fund but doesn’t hold exactly the same investments.

Payment-in-kind redemption “is mathematically possible, and people should be alerted to the possibility,” says mutual-fund analyst A. Michael Lipper, president of Lipper Advisory Services, an investment adviser in Summit, N.J. “But given the size of the fund, the size of Pimco and the size of its parent company, I think the odds are something like 1 in 150.” Pimco is owned by German insurer Allianz SE.

But if this hypothetical and unlikely scenario did turn out to be real, large sellers of Pimco Total Return could be handed a grab bag, representative of the fund’s more than 6,000 holdings, that could include Spanish and Greek government bonds, mortgage-backed securities, bank loans, municipal bonds, foreign-currency contracts, interest-rate swaps, credit-default swaps and other complex “derivatives.”

Under Securities and Exchange Commission rules, all redemptions in kind should be handled equally; Pimco couldn’t give U.S. Treasury bonds to one big investor while sticking the others with Greek and Russian debt.

An investor receiving “odd lots” of unusual or illiquid bonds and derivatives would have a hard time selling them without incurring at least a small discount from the prices at which they were carried on the Pimco fund’s books, says Mr. Lipper.

None of this would apply to investors who have less than $250,000 in the fund.

But big investors have to ponder an unusual risk right out of game theory. If too many other large holders of the fund rush for the exit, Pimco could feel it needs to impose payment-in-kind redemptions to slow down the outflow. Anyone who redeemed before that happened would be lucky enough to get cash. Those who took their time leaving, however, could end up being paid in kind.

The very suspicion that redemptions in kind might be used, says Mr. Lipper, could prompt some large investors to redeem when they might not otherwise be inclined to do so.

He hastens to add that many funds may be improved, in the long run, by moderate amounts of forced selling in the short run — since the managers may have to eliminate all but their favorite holdings.