PIMCO should bring policies in line with its world-class reputation.
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By Eric Jacobson | 02-07-11 | 06:00 AM | Email Article

PIMCO isn't just one of the biggest asset managers in the fund industry. It's also one of the very best.

It has a record of delivering excellent returns for most of its clients. It boasts a culture that, while obsessive, high-pressure, and ultracompetitive with its rivals, keenly understands risk from almost every angle. That starts at the level of individual holdings, but PIMCO managers pay an enormous amount of attention to portfolio-wide dangers, the macroeconomy, and even risks to the reputation of its entire franchise. All in all, it is a world-class organization.

Eric Jacobson is a senior analyst covering active strategies on Morningstar’s manager research team.

But the P in PIMCO does not stand for "perfect." One flaw is the firm's structure of mutual fund pricing, disclosure, and governance. That stands in odd contrast to the otherwise investor-centric nature of its overall culture.

The good news is that there are signs PIMCO may finally be willing to address some of those shortcomings. The firm recently announced it will soon take over all sales and distribution tasks for its retail (noninstitutional) share classes, which had long been handled by another subsidiary of parent Allianz. The head of its new distribution operation has hinted in some interviews that fee cuts of some type are on the horizon.

That could benefit shareholders of PIMCO's funds. But in order for the stature of its mutual fund house to approach PIMCO's deserved reputation as an asset manager, the firm will have to address other issues.

Independence Day
One key issue is just who gets to sit on and ultimately control the board of directors of the PIMCO funds. Morningstar views board independence as a cornerstone of good mutual fund governance. Therefore, when calculating Stewardship Grades for funds, Morningstar awards credit only to fund boards with independent chairmen and a membership that is at least 75% independent. PIMCO's fund board does not meet either criteria, given that board chairman Brent Harris is a long-tenured PIMCO executive, and only five of the board's seven trustees are independent. (The firm's new equity funds are overseen by a board of three people, each of whom sits on the bond funds' board as well; Harris is the chairman of that board, which also falls short of Morningstar's 75% independence threshold.)

PIMCO questions the need for an independent chairman and a higher level of independent board membership. The firm has been adamant that its board serves investors well. Harris has argued that board members historically have been carefully recruited for their experience and business judgment and has noted that issues requiring a vote of the board--such as fees, board compensation, and oversight of the chief compliance officer--also require the presence of independent board counsel and a recusal of management. In fact, Harris has said that, if anything, more input from fund management is needed in full board meetings to provide balance for discussions that occur in insular, independent trustee meetings. He believes that efforts to reach higher ratios of board independence risk the inclusion of unqualified members.

Any Club That Will Accept Me as a Member �
There seems to be little risk of the board being infiltrated and overwhelmed by unqualified newcomers, though. One reason is the lock-tight control it exerts on its own membership. In fact, the rules governing how new members may be nominated to the board are more restrictive and potentially exclusive than any others Morningstar has ever observed among open-end mutual funds.

The criteria are laid out in PIMCO funds' Statement of Additional Information and, in simplified form, look like this: You have to own at least 5% of a fund and have done so for at least two years, just to nominate someone for the board. The nominee can't be you, anyone you're closely related to, or anyone who works for you. In other words, it's extremely difficult for a shareholder of any size to get on the PIMCO funds' board or, for that matter, to freely choose another nominee for the position. Even if you somehow had more than $12 billion--5% of its current net assets--in  PIMCO Total Return , for example, you still couldn't nominate yourself for a seat on the board.

Morningstar has raised this issue with PIMCO and the board, and it turns out the rules were adopted from a 2003 SEC proposal (revised at least once thereafter, but never implemented) that was apparently designed to try to ease proxy access to corporate boards for shareholders of regular operating companies. Although that proposal seems woefully inadequate and ill-suited to open-end mutual funds, it appears PIMCO looked favorably on the restrictive rules as a means of protection from takeover tactics common to the closed-end fund universe.

Whatever the origin or intent, however, the rules effectively prevent shareholders from choosing who will represent their interests on the board. It's frankly shocking that an asset manager as good as PIMCO runs funds with a governance structure this bad.

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Eric Jacobson has a position in the following securities mentioned above: PTTRX Find out about Morningstar's editorial policies.
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