Pimco Bond Guru Bill Gross : Pimco Allowed Market Timers !!!!

» Kirk - Pimco Allowed Market Timers !!!!

If this is true, this could be the end of Bill Gross's fame. ]

Pimco Bond Funds Had Different Rules for Big Investors, Documents Indicate
http://www.miami.com/mld/miamiherald/bus...

Posted on Mon, Mar. 15, 2004

The Orange County Register, Calif. Knight Ridder/Tribune Business News

Mar. 14 - If you're a cautious mutual fund investor who's always been coached to buy and hold, the Newport Beach-based Pimco bond funds have probably appeared, over the years, a very safe place to practice that strategy.

Pimco indicates in its prospectus that it's watching out for rapid trading in its funds, and for other practices that might harm fund performance.

"In particular a pattern of exchanges characteristic of "market-timing" strategies may be deemed by Pimco to be detrimental...," the prospectus warns. "(Pimco) has the right to refuse any exchange for any investor who completes ... more than six round trip exchanges in any 12-month period."

Even if you were tempted to trade every two months, you were likely to get a call from Pimco's market-timing monitors. Some investors were told they had to hold Pimco funds for at least six months -- or trade elsewhere.

But it turns out there's a lot of wiggle room in those apparently stern warnings.

And a lot would depend on who was doing the trading.

When a consultant representing New Jersey millionaire Edward Stern, heir to the Hartz Mountain pet supply fortune, offered to invest $20 million in late 2002 -- if he could trade in and out at least once a month -- Pimco quickly agreed.

"We have always shunned these 'timers' in the past but wanted to get your current read," a Pimco marketing executive e-mailed High Yield portfolio manager David Hinman.

"At $4B in (the fund) we can handle $20 mm in timer money," Hinman replied.

By April 2003, Stern was moving $30 million into and out of the High Yield Fund at least once a month -- and was offering to invest $150 million more if he could get the same deal.

"We are able to take another four separate clients up to $20 million each into the domestic public High Yield Fund provided they each trade on a separate day," replied Andre Mallegol, a Pimco vice president of marketing, in an e-mail to a Stern representative on April 30, 2003.

In a fraud lawsuit filed last month, New Jersey Attorney General Peter C. Harvey, alleges that those arrangements constituted a secret agreement that allowed Stern to trade in excess of Pimco's publicly disclosed limits.

Pimco declined to be interviewed for this story.

But in an interview with The Register last month, Bill Gross, the Newport Beach bond investment chief and two-time Morningstar Fixed-Income Manager of the Year, denied the fraud charges.

Gross said the rules in the fund prospectuses were not broken and no investors were hurt by any of the rapid trading. He said Pimco agreed to allow Stern's Canary Capital Partners limited market-timing in order to bring its trading under control.

But many experts say the venerable Newport Beach bond house appears to have broken faith with small investors.

"You are giving the impression that you will discourage market timing in order to protect the small investors. Having done that you turn around and leave them vulnerable," said John C. Coffee, a Colombia University professor and expert in securities law.

In addition to Pimco, the fraud lawsuit names Pimco Equity Advisors (PEA), the New York stock fund managers, Pimco Advisors Distributors (PAD), the Connecticut sales arm for the stock and bond funds and Allianz Dresdner Asset Management, the company which owns the controlling interest in the entire Pimco funds operation.

The fraud charges against Pimco Equity Advisors--the first of the Pimco fund family to give Canary written permission to market time in its funds, make up the bulk of the NJ complaint and appear more serious. PEA had the same six-trade rule in its prospectus but allowed Canary as many as 37 round-trip trades in some of its funds in less than 10 months.

A spokesman for PEA acknowledged last month that fund managers had allowed Stern to market time some of their stock funds in 2002. But the spokesman said PEA "eventually came to the belief that they had been misled about (Stern's) intentions and strategy and called (the arrangement) off after a number of months."

But it is the allegations against the Newport Beach bond house -- which had insisted in early February it was not involved in market timing--which have shaken up the mutual fund world. That relatively stable bond funds could be timed in the first place surprised some fund watchdogs. That Pimco was involved stunned them.

"Early in the scandal, when people were putting together a list of the good guys, Pimco was on this good-guy list," said Roy Weitz, a mutual fund analyst and founder of FundAlarm.com, which warns consumers about troubled funds.

"They were sitting on top of the world and acted like nothing could touch them. Now they've been cut down a notch."

The marriage between Pimco and PEA Capital, as it's now known, was always one of convenience.

The stock funds took on the Pimco name when they were created in 1999 to trade on the fame of their better-known bond half, which had been building its reputation since 1971.

The bond and stock funds operated independently -- but documents attached to the New Jersey fraud lawsuit show that both had an official policy discouraging market timing.

Since 2000, Pimco Advisor Distributors had send out more than 700 letters to investors enforcing the market timing rules, the lawsuit says. The letters asserted "Pimco does not allow this type of activity to occur in our funds."

Pimco employees telephoned investors who traded too often.

"Spoke w/Mary (very nice)," a Pimco Advisors Distributors market-timing log for October 1998 says. "They traded $1.4 (million in Pimco's High Yield Bond Fund) via Schwab--held less than 45 days. Explained we had a six-month minimum hold. She agreed not to use it."

But in late 2001 executives at Pimco Equity Advisors met with brokers for Edward Stern, general manager of a $700 million hedge fund named after one of the biggest consumers of Stern's Hartz Mountain products, court documents show.

Stern wanted to be able to move in and out of the stock funds as often as five times a month, his representative told PEA. In return Canary would make a long-term investment in a PEA stock or Newport Beach bond fund.

The deal eventually struck put the long-term assets in the stock fund managed by PEA chief executive Kenneth W. Corba -- PEA Select Growth.

When it wasn't moving into the stock funds, Canary parked its trading money in Pimco short-term bond and money-market funds, the lawsuit alleges. At one point in February 2002, it made 89 transactions in the Newport Beach funds in three days.

Steve Howell, a Connecticut-based market-timing cop for Pimco Advisor Distributors, saw the rapid trading in Pimco's stock and bond funds in early 2002, but didn't blow the whistle.

In a sworn deposition, Howell told New Jersey investigators he did nothing about the market timing -- although he considered it abusive -- because high-ranking executives at Pimco Advisors -- the Connecticut marketing arm -- had warned him that the accounts would have frequent transactions "and directed us not to pursue that."

"This whole arrangement was put together by, you know, people above me and ... I didn't feel like I was in a position to question what had been established," he said.

How much the Newport Beach fund managers knew in early 2002 about the deal struck between PEA and Canary is unclear.

Gross told The Register last month Pimco's Newport Beach fund managers weren't part of the arrangement.

"We really didn't know what they were doing," Gross said in an interview.

The fraud lawsuit says bond fund managers "did not appreciate the frequent exchanges in and out of the money market and bond funds..." There are some indications that Canary may have eased off on bond transactions in mid-2002.

But in October Canary's market-timing consultant, Dave Byck, approached the Newport Beach bond fund officials directly.

"David -- we have an advisor who has a HNW (high net worth) investor who wants to put $20 million in the hyld fund and have the ability to move in and out roughly once a month," Pimco senior vice president of marketing Doug Ongaro e-mailed High Yield Portfolio manager David Hinman on Oct. 1, 2002.

Pimco subsequently agreed to take $30 million from Canary, and as Stern began trading that in early 2003, Byck e-mailed Pimco with the request to invest as much as $150 million more.

The e-mail's subject line read: "More money?"

Then came a response that still has experts disagreeing,

"We are able to take another four separate clients up to $20 million each into the domestic public High Yield Fund provided they each trade on a separate day," Mallegol, a Pimco vice president of marketing, responded to Byck on April 30.

"Consecutive days are OK although we would prefer every other day at the most. After these four come into the fund we will not be taking others unless they are buy and hold investors."

Pimco subsequently accepted another $50 million from Canary, the court documents indicate, including two accounts totaling $20.5 million in the domestic High Yield bond fund and three accounts totalling $30 million in the Pimco Real Return Fund.

"It looks to us like they had an agreement to market time well beyond what they allowed others to do. It was a special arrangement," Franklin L. Widmann, chief of the New Jersey Bureau of Securities said in an interview.

Coffee and some other experts agree.

"That's far more than allowing this (market timing), that's inviting it. That is putting a 'For Sale' sign out front," Coffee said.

Mutual fund research company Morningstar doesn't agree, calling the evidence "troubling" but inconclusive.

"The complaint seems to be reaching too far to try and illustrate malfeasance," Morningstar analyst Eric Jacobson wrote.

Gross has said that trades in the Newport Beach bond funds never violated the prospectus.

But there is not enough information included in the court filings to verify or contradict his claim,

The 89 transactions alleged in February 2002 -- which possibly could have exceeded the six-in-a-year limit -- are not detailed in the case documents.

There are exhibits detailing the Canary trades in 2003 -- after Pimco specifically agreed to allow market timing.

None of those show more than six trades into and out of any individual fund -- the buy-and-sell transaction limit set by the Pimco prospectus.

For fund companies, the reason for allowing large market timers to invest in your fund is simple: more management fees.

Advisor fees typically equal a percentage of the funds' assets -- in most of the Pimco funds, that was .25 percent. When the fund gets bigger, they bring in more money.

"(The fund managers) were looking for market timers to improve their revenues," said Weitz, the mutual fund watchdog. "They were just attempting to goose the fund with some extra assets."

Still, the approximately $40 million balance that Canary kept in various Pimco funds for about seven months in 2003 is a tiny fraction of the $374 billion Pimco has under management -- and would generate perhaps $50,000 in fees.

Securities law experts like Columbia University's Coffee, and the University of San Diego School of Law's Frank Partnoy say its likely that Pimco was allowing other large hedge funds to invest as well -- since the managers didn't believe their activity was harming the funds.

"Canary was very aggressive, and was able to convince a lot of people, not just Pimco, to give them special treatment," said Partnoy, who is the author of "Infectious Greed: How Deceit and Risk Corrupted the Financial Markets."

For Canary, successful market timing had a large potential upside.

Experts say bonds held by a municipal or high yield fund may only trade once every week or two so their assigned value in the fund gets "stale," not reflective of recent movement in the overall bond market. Sophisticated timers who calculate such changes can make an extra 10 percent to 25 percent over those who buy and hold a bond fund.

But it's not clear how sophisticated Canary's trades were. At times the giant hedge fund bought high and sold low.

An Orange County Register analysis of Canary trades in the Pimco Real Return Fund -- based on a chronology attached to the lawsuit and the fund's net asset value, as tracked by Bloomberg -- shows that Canary bought in Aug. 7 in three accounts totalling $30 million at a net asset value of $11.23.

The share price then began to fall and on August 13 Canary sold about half of its shares at $11.14 -- thus missing a rally that began a day later and took the share price back up to $11.32 on Aug. 19.

Canary then bought back in -- and the shares sagged again. They dumped just under $15 million worth on Sept. 2, at a share price of $11.18, then bought back in Sept. 4, at $11.22, and caught a rally that took the shares to $11.42 on Sept. 10.

They then redeemed all their shares over the next two days, exiting with a profit of $180,333, according to the court documents.

An investor who had bought in with $30 million and stayed in the fund during the same period that Canary was moving in and out would have earned far more -- $401,614 before paying any fees or commissions.

The attorney general implies that Canary's trading investments harmed small investors in the fund, siphoning off short-term profits while contributing nothing that could earn dividends for Pimco share holders.

Experts agree that is likely, noting that fund managers keep volatile investments such as market timer funds in cash -- meaning no stock or bonds are purchased with the timer money.

But because the bond funds in which Stern was playing are so large -- $4 billion to $9 billion -- their effect is measured in fractions of a percent.

[Kirk's Editor Comment: Anyone besides me get tired of this crap saying "We stole $50K from small investors but it was such a small percentage of their total net worth"?
What a load or horse manure! ]

In a 2002 paper for the Journal of Financial Economics, Jason T. Greene and Charles W. Hodges estimated that market timers cost the average mutual fund about .28 percent per year in transaction costs and lost earnings from holding their cash instead of investments.

So an investor with $50,000 in a fund with market-timers at play might lose $140 in earnings over the course of a year; one with $5,000 would lose $14.

[Kirk's Editor Comment: $14 is a nice lunch... People with 401K accounts have far more than $50K in Pimpco Bond funds... ]

Kunal Kapoor, director of fund analysis at Morningstar, a Chicago-based independent investment research firm, said it doesn't really matter whether smaller Pimco shareholders lost any money in these deals.

"It's a question of intent," he said. "One of the reasons people buy mutual funds is that it's essentially paying for equal access to an investment, where you are getting the same rights as every other shareholder," Kapoor said.

Gross said in a letter sent to clients last month that he wishes Pimco had never attracted Stern and Canary.

[Kirk's Editor Comment: Nixon wishes he never brought a tape recorder into the White House ]

He told The Register he wants Allianz AG, their Munich-based parent, to grant them a "divorce," formally separating PEA from Pimco.

Still, Gross said, he believes Canary's trading "harmed no shareholders. If any investor in our funds was disadvantaged by this arrangement, then we want to give assurances we will make it up -- in full."

Morningstar analyst Jacobson recommended last week that people holding PEA stock funds consider selling. But he was less critical of the Pimco bond funds, saying only that some employees "appear to have used poor judgement" in their dealing with Canary.

"One would frankly hope that anyone approaching the firm and even breathing the term "market-timing" would have been shown the door without delay," Jacobson wrote.

There's a lot at stake here for Gross and Pimco.

Most of its bond funds have Morningstar's top--five star--rating.

Gross appears as an expert commentator on both CNBC and CNN.

When Munich-based insurer Allianz AG bought a controlling interest in Pimco from Pacific Life Insurance in 2000, they gave Gross a seven-year contract that pays him $40 million annually for the first five years.

Allegations that portray the bond funds' practices as "down there at the bottom of the barrel," as Gross put it in his client letter, have damaged a reputation that took him 30 years to build.

The California Public Employees Retirement System is considering removing Pimco as a manager of its $208 million bond portfolio.

"They've taken a significant reputational hit," said Nell Minow, founding principal of The Corporate Library, an independent investment research firm in Maine.

But Robert Adler, president of AMG Data Services in Arcata, which monitors mutual fund inflows, said the charges don't appear to have deterred investors so far.

For the week ended Feb. 25, the most recent information available, Pimco's taxable bond funds got $1.2 billion in new money; the money market funds $22 million and municipal bond funds $28 million. Adler said that might be slightly off January's weekly inflows, but only because January was a record month for the industry.

That contrasts with investors' flight from Putnam Investments, which, according to Financial Research Corp., saw more than $23 billion in redemptions in the four month after the SEC and Massachusetts attorney general brought civil suit against the mutual fund and two former managers for allowing market timing. Putnam lost $13 billion in the first month alone.

"I don't see any evidence that Pimco's been affected," Adler said.

--By Chris Knap and Mary Ann Milbourn

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-- posted by Kirk