PIMCO September Asset Flows Special Report

? PIMCO September Asset Flows Special Report Manager Research 2 October 2014 Timothy Strauts Markets Research Manager +1 312-384-3994 timothy.strauts@morningstar.com Michael Rawson Analyst +1 312-696-6079 michael.rawson@morningstar.com Jon Hale Director of Manager Research, North America +1 312-696-6093 jon.hale@morningstar.com Outflows Could Be Stabilizing After the Shock of Gross Departure estimates* that PIMCO Total Return experienced $17.9 billion** of outflows in September. This number excludes the roughly $5.6 billion of outflows that occurred on Tuesday, Sept. 30 but were not processed until after the close. The combined $17.9 billion and $5.6 billion outflow matches the $23.5 billion outflow mentioned in PIMCO s press release. Throughout this document, all flow numbers exclude flow activity from orders placed on Sept. 30, as industry practice reports the impact of these trades with a one-day lag. The unprecedented magnitude of September s activity reflects investors response to the surprise departure of the fund s manager, Bill Gross. In the press release, PIMCO stated that outflows were highest on Friday, Sept. 26, the day Gross exited, but were considerably smaller on Monday and Tuesday, the last two days of the month. This is consistent with the outflows we observed in PIMCO Total Return ETF, which suffered outflows of 13% on Friday, followed by outflows of 3% on both Monday and Tuesday. The ETF outflows fell to 1% on Wednesday, Oct. 1. It is also consistent with our estimate that investors pulled about $20 billion from the PIMCO Total Return mutual fund between Friday and Wednesday, Oct. 1, with the volume decreasing since Friday. The fund was already averaging about $3 billion in monthly outflows during 2014 prior to Gross departure. PIMCO does not release daily flow information, but unconfirmed reports pegged Friday outflows at around $10 billion. As noted above, we know that $5.6 billion exited on Tuesday, which means Monday s outflow was likely in the same neighborhood. Funds Previously Managed by William Gross Manager Flow PIMCO Total Return Mihir Worah, Mark Kiesel, Scott Mather 201.6-17.9-22% QQQQ PIMCO Low Duration Jerome Schneider, Scott Mather 20.0-2.2-18% QQQQ PIMCO Unconstrained Bond Daniel Ivascyn, Mohsen Fahmi, Saumil Parikh 18.3-3.2-38% QQQ PIMCO Fundmtl Advtg AR Strat Mohsen Fahmi, Robert Arnott, Saumil Parikh 4.1 0.4 42% QQQQQ PIMCO Fundmtl IndexPLUS AR Mohsen Fahmi, Robert Arnott, Saumil Parikh 3.8-0.3 17% QQQQQ PIMCO StocksPLUS AR Short Mohsen Fahmi, Saumil Parikh 5.1 0.0-18% N/A PIMCO StocksPLUS Sudi Mariappa 1.1-0.1 14% QQQQQ PIMCO Total Return grew to become, at one point, the world s largest mutual fund thanks to performance that ranks in the 4th percentile of its peer group over the trailing 15-year period

of 9 through September 2014 and massive inflows, especially as investors fled en masse from other asset classes to the perceived safety of fixed income in the wake of the financial crisis. Exhibit 1 shows assets in PIMCO Total Return during the past decade. Those assets peaked at $293 billion in April 2013. Over the five years prior to that peak, the fund accumulated $93 billion of inflows, averaging $1.5 billion per month. Since assets peaked in 2013, the fund has seen 17 consecutive months of outflows, prompted at first by the Fed s so-called taper tantrum but kept alive by the fund s uncharacteristically lagging performance. Over this span, the fund s assets have dropped to $202 billion and outflows have totaled $87 billion, averaging $5.1 billion per month. Exhibit 2 shows monthly flows during the past two years for PIMCO Total Return. Earlier in 2014, outflows had moderated somewhat, averaging $3.1 billion per month prior to September. This suggests that about $15 billion of September s $17.9 billion outflow could be attributed to Gross departure. September s outflow accounts for 8% of fund assets. During the past 10 years, outflows never exceeded 3% for a month, and they totaled 9% over the threemonth span in the summer of 2013. While the spike in outflows from Gross departure was to be expected, particularly coming so close to quarter-end when many investors are rebalancing, the outflows are not so high that they appear to have caused much disruption for the fund or for bond markets. Exhibit 1. PIMCO Total Return Net Assets

of 9 Exhibit 2. PIMCO Total Return Net Monthly Flows Assessing Flows and Liquidity at PIMCO Total Return PIMCO Total Return remains the world s largest bond fund, with assets now hovering around $200 billion. Additionally, PIMCO managed approximately that same amount of assets in separately managed accounts run in the same style, as of the end of 2013. In total, that s around $400 billion in the strategy, accounting for more than a fourth of the assets PIMCO runs for clients globally. The abrupt departure of Gross has raised concerns about the possibility that the firm could suddenly lose significant assets from its flagship fund managed by Gross. Outflows Some of that money can leave quickly, as we ve seen in the immediate aftermath of Gross departure, and some of it more slowly. Separately managed accounts run for large institutional clients are not going to go away overnight. Such accounts are monitored by investment committees and advised by consultants who are deliberate in their consideration of manager changes and other material events. They typically put a manager on watch while evaluating the changes and looking for potential replacements. It takes time to open a business relationship with a new manager and ultimately to move the money. When the money does move, it does so in an orderly fashion. It is therefore unlikely that PIMCO will lose a significant number of separately managed accounts right away. Indeed, because these accounts will benefit from careful due diligence, in many cases, PIMCO will have the opportunity to prove itself with its new team in place. In cases where PIMCO does lose an institutional account, the transition will be done in a planned way that aims to minimize disruption. It s also worth noting that institutional clients have widely differing timetables for making changes; thus, it s unlikely that large numbers of accounts would walk out the door at the same time.

of 9 Mutual funds are another story. They experience daily flows via investor purchases and redemptions that, in most cases, PIMCO doesn t know anything about until they get the news every day after market close. Because PIMCO Total Return had uncharacteristically underperformed during the past two years, investors had already been pulling money from the fund prior to Gross departure. Total assets under management for the fund had fallen to $222 billion at the end of August from a peak of $293 billion in April 2013, before investors pulled the additional $17.9 billion from the fund during September. Liquidity The question for those who remain invested in PIMCO Total Return is whether the fund can withstand such significant redemptions without punishing remaining shareholders with terrible returns from having to sell assets at fire-sale prices. Our rough estimate is that the portfolio, as of the end of August, had about $80 billion in holdings PIMCO considered to be highly liquid cash equivalents. Here is an estimate of how that breaks down: 16% government-related debt 16% short-term credit 1% short-term mortgage 3% short-dated asset-backed securities, CPs, and CDs That is 36% of approximately $222 billion in net assets, as of August. PIMCO had much more in longer-maturity, but still fairly liquid, marketable securities that it could sell in an orderly fashion. It had about $29 billion worth of market exposure to agency mortgage-backed securities and TBAs, as of August. Average daily trading volume of the agency MBS market in August was $167 billion, according to SIFMA. Finally, the fund gets a steady stream of income through coupon payments, bonds that are called, and mortgage prepayments. This provides a healthy cash flow that the fund can use to meet redemptions. There is reason to believe PIMCO liquidated a slice of the portfolio to increase its cash equivalents position by roughly 10 percentage points in recent days, but it is difficult to handicap the extent of that liquidation or what the fund's exact liquidity position is given heavy daily redemptions from the fund. The situation could also become much more challenging in coming weeks or months if outflows accelerate. It could increase the relative size of the fund's less liquid positions, although the fund's combined stake in less liquid nonagency residential mortgage-backed securities and high yield clocked in at a relatively slim 10% to 15% of assets as of late. Meeting heavy redemptions could also crimp management's ability to adjust the portfolio although the firm does have an interfund trading policy, it's difficult to gauge at this point if or how much that could mitigate the impact of selling from PIMCO Total Return. Taken together, we expect the fund and the market to be able to handle significant redemptions. After the initial wave of redemptions breaks, we expect the waters to calm a bit. Many advisors and investors who didn t bolt for the exits will take a wait-and-see approach. Investors in the Institutional shares of the fund are likely to be deliberate in their decision-making as well,

of 9 for many of the same reasons we gave above for those in separately managed accounts. Meanwhile, most participants in tax-free retirement plans tend not to make a lot of changes to their accounts, and many DC plans lack additional bond-fund choices, so even if plan participants wanted to make a change they would have to wait for the investment committee to make changes to the fund lineup. Yet, we could see an uptick in outflows related to plan sponsors in early January 2015. We will move quickly to reassess our views as new information becomes available. Although PIMCO releases flow data monthly (not daily), remains in daily contact with the firm, in part to assess the potential ramifications from outflows at PIMCO Total Return, in particular, and, to a lesser extent, strategies across the firm's fixed-income lineup. While PIMCO Total Return will be significantly smaller after all is said and done, the overall assets under management for the strategy (funds plus separately managed accounts) are likely to remain sufficiently large that we don t expect major negative firmwide ramifications, such as pressure to reduce headcount, compensation, or resources. Our best guess at this point is that PIMCO will weather the storm. PIMCO s Firm-Level U.S. PIMCO Total Return now accounts for roughly 42% of PIMCO s long-term, U.S.-domiciled fund assets (excluding money market funds, separate accounts, and subadvised funds). Fund assets at the firm peaked at $614 billion in April 2013, allowing the firm to double its industry market share in five years and become the fourth-largest provider of U.S funds--up from seventh at the start of the period. Exhibits 3 and 4 show PIMCO s long-term fund assets and flows, respectively. Exhibit 3. PIMCO U.S.-Domiciled Fund Firm-Level Assets

of 9 Exhibit 4. PIMCO U.S.-Domiciled Fund Firm-Level Monthly Estimated Net Flows Has Updated its Stewardship Rating for PIMCO and its Analyst Rating for PIMCO Total Return in the Wake of Gross Departure has updated its Stewardship Grade for PIMCO, maintaining an overall grade of C. You can read the full report here. Also, we have lowered our Analyst Rating for PIMCO Total Return to Bronze from Gold. Our full Global Fund Report for PIMCO Total Return can be found here. Outflows Worse Than Category PIMCO Total Return suffered heavy redemptions amounting to $9.7 billion and 3% of assets during the June 2013 taper tantrum, yet outflows started to moderate for the fund and turned positive for the intermediate-term category in February 2014. As Exhibit 5 shows, flows to the category have stayed positive since that time through the end of August, but flows to PIMCO Total Return have continued to be negative as its returns continued to lag. From April 2013 through September 2014, the fund s cumulative organic growth rate (flows divided by beginning period assets) is negative 30%. Exhibit 6 highlights the cumulative organic growth rate of several other relevant PIMCO funds.

of 9 Exhibit 5. Cumulative Since April 2013 Exhibit 6. Other Large PIMCO Funds Cumulative Since April 2013

of 9 The tables below list significant PIMCO funds managed by the new CIO and the new Total Return managers. Funds Previously Managed by Scott Mather Manager Flow PIMCO Foreign Bond (Unhedgd) Andrew Balls, Lorenzo Pagani, Sachin Gupta 2.5-0.1-21% QQQQ PIMCO Foreign Bond (Hedged) Andrew Balls, Lorenzo Pagani, Sachin Gupta 7.2 0.0 12% QQQQQ PIMCO Global Bond (Unhedged) Andrew Balls, Lorenzo Pagani, Sachin Gupta 0.8 0.0-14% QQQQ PIMCO Global Bond (Hedged) Andrew Balls, Lorenzo Pagani, Sachin Gupta 0.5 0.0-2% QQQQ Funds Managed by Mark Kiesel Flow PIMCO Investment Grade Corporate Bond 6.1 0.4-18% QQQQQ PIMCO Long-Term Credit Bond 5.6-0.4-14% QQQQQ PIMCO Credit Absolute Return 1.5-0.4-36% QQQQ Funds Managed by Mihir Worah Flow PIMCO Real Return 15.2-0.2-17% QQQQQ PIMCO Commodity Real Return Strategy 13.1 0.0-14% QQQQ PIMCO Global Multi-Asset 1.2 0.0-67% Q PIMCO Real Estate Real Return Strategy 2.2-0.4-30% QQQ PIMCO Real Return Asset 1.0 0.0 60% QQQQQ PIMCO Inflation Response Multi-Asset 1.3 0.0 10% Q Fund Managed by Daniel Ivascyn Flow PIMCO Income 38.6 0.8 30% QQQQQ **Our estimate differs from PIMCO s reported $23.5 billion outflow because the flow estimates that PIMCO provided included redemption requests made on Sept. 30 but not effected in fund shares outstanding until Oct. 1. This is known as a T+1 settlement cycle and applies to all PIMCO U.S.-domiciled funds. Because PIMCO provides only accounting assets to on a monthly basis, the redemption requests made on Sept. 30 are not included in our estimate. PIMCO has indicated to that $5.6 billion in net redemptions were requested on Sept. 30. These redemptions will be reflected in our October estimates.

of 9 *Important methodology note: estimates open-end fund net flows by computing the change in assets from one month to the next that is not explained by the performance of the fund. The fund s actual flows may differ from s estimates for a variety of reasons, including the timing of actual purchases and redemptions versus our assumptions and the timing and type of dividend distributions, for example. Click here for a full explanation of s estimated flow methodology. K? 22 West Washington Street Chicago, IL 60602 USA 2014. All Rights Reserved. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of. To order reprints, call +1 312-696-6100. To license the research, call +1 312-696-6869.