Aug. 6 (Bloomberg) — When Bill Gross started Pimco's most recenteffort to expand into stocks three years ago, he vowed not torepeat the mistake he made in the 1980s, when his bond tradersoverwhelmed a handful of equity managers at strategy meetings,eventually prompting them to quit.

Last week, the manager of the world's largest bond fund atPacific Investment Management Co. in Newport Beach, California,compared long-term returns from equities to a “Ponzi scheme” andsaid returns of 6.6 percent above inflation, known as the SiegelConstant, won't be seen again. “The cult of equity is dead,” Gross,68, said in an Aug. 2 interview with Betty Liu on BloombergTelevision.

“I can imagine the equity managers cringed the same waycorporate-credit managers cringed when he said earlier in thedecade he wouldn't buy a corporate bond at any price,” said BillPowers, who worked at Pimco from 1991 until 2010 and was a memberof its investment and executive committees. “Bill will always speakhis mind about value in the markets.”

The dismissal of a long-held belief among stock pickershighlights the challenge Pimco faces in building an equitiesbusiness while aligning its managers with an economic philosophyoutlined by bond king Gross that predicts diminished returns acrossasset classes. Since starting its first equity strategy in 2010,Pimco has gathered $3.2 billion in the four main stock funds, lessthan 1 percent of the firm's $1.8 trillion, held back by investoraversion to equity funds and subpar performance. The firm's fourmain stock funds are trailing a majority of rivals this year.

'Invest Globally'

Neel Kashkari, the former head of the U.S. government's TroubledAsset Relief Program who was hired in December 2009 and overseesPimco's global equities, said Gross's comments are consistent withPimco's outlook for stocks in a “new normal” environment ofbelow-average economic growth.

“This makes it even more important to invest globally andactively select the companies best-positioned to deliver attractivereturns,” Kashkari, 39, said in an e-mail.

Pimco's first two equity strategies, EqS Pathfinder Fund and EqSEmerging Markets Fund, account for about $2.6 billion of the firm'sstock assets. Neither is beating its benchmark index in 2012, andboth lagged behind at least 62 percent of peers as of Aug. 2,according to data compiled by Bloomberg.

EqS Emerging Markets Fund, which began in March 2011, andPimco's third equity strategy, EqS Dividend Fund, which started inDecember, have attracted less than $900 million in combined assets.Gross's Total Return Exchange-Traded Fund, an ETF variation on hisflagship fixed-income mutual fund, has soared to $2.4 billion inassets since it was started five months ago.

First Experiment

Pimco first experimented with stocks in the mid-1980s, a foraythat was short-lived when the equity managers quit after about twoyears. Lessons from that time, when bond traders would shoot downequity managers' bullish arguments for stocks during strategymeetings, led Gross to try to give the equities team more freedom,he told Bloomberg Markets magazine in its August 2010 issue.

“Those sessions basically said, 'Hey, we're a bond shop. This iswhat we're going to do. It's the party line,'” Gross said in the2010 interview. “If I've been a problem, then I can be the solutionin terms of allowing equity investments to grow and prosper.”

Another effort was set up in 1999 by Pimco's then-parentcompany, which created an equity unit separate from the bondbusiness to take advantage of the Pimco name. Five years later theunit was one of several fund companies accused by the Securitiesand Exchange Commission of allowing a hedge fund to engage inmarket timing, a practice of making short-term trades to exploitmarket inefficiencies, and was dissolved after paying fines andrepayments to settle the lawsuits. It didn't admit or denywrongdoing.

'Stepchild' Funds

Pimco's latest stock effort came as Gross anticipated anend to the 30-year bond rally, which helped fuel Pimco's growthsince Gross co-founded the firm in 1971. The prediction wasundermined as Europe's sovereign-debt crisis sent investors to theperceived safety of bonds and out of stocks. Stock funds have seenclient withdrawals in every year since 2008.

Investors have pulled about $197 billion from stock funds sincethe start of 2010 through this June, according to data from theInvestment Company Institute, a trade group based inWashington.

“No one should be surprised that Pimco equity funds are astepchild,” said Joshua Brown, vice president of investment for NewYork-based Fusion Analytics Investment Partners LLC, which has partof its $300 million under management in Pimco bond funds. “Whatthey have against them is distaste for open-end mutual funds,dislike for equities and the fact that it's a bond shop ineveryone's mind.”

Gross's Apology

Gross's forecast also prompted an ill-timed move out of U.S.Treasuries last year, resulting in the worst performance for his$263 billion Total Return Fund relative to peers based on recordsgoing back to 1995. Gross, who apologized to clients for theunderperformance in a letter calling 2011 a “stinker,” reboundedthis year to beat 98 percent of rivals. The fund has alsooutperformed 98 percent of peers over five years.

Pimco has added smart stock pickers who will benefit from thefirm's resources and be compatible with its macroeconomic view of alarger global role for developing nations, said Kashkari, who alsoworked as an investment banker at Goldman Sachs Group Inc. Thefirm, which manages $1.82 trillion in assets, has hired about 50people for its equity strategies, which are all globallyfocused.

Franklin Team

Anne Gudefin and Charles Lahr, former Franklin ResourcesInc. managers, were brought in to oversee the first stock fund, EqSPathfinder. The $2.13 billion fund's managers follow a deep- valuestrategy of picking stocks they consider to be cheaper than they'reworth. In the 12 months through Aug. 2, it declined 0.2 percent,putting it ahead of 66 percent of similarly managed funds,according to data compiled by Bloomberg. This year the fundreturned 4.1 percent, trailing 62 percent of peers.

The Pathfinder fund follows a more conservative strategy andtends to hold more cash so it hasn't benefited as much from thisyear's stock rally, said Karin Anderson, a senior mutual- fundanalyst for Morningstar Inc. The MSCI ACWI Index of global stocksis up 6.2 percent and the U.S. benchmark Standard & Poor's 500Index has risen 11 percent this year through Aug. 3.

Gross's Total Return Fund returned 7.6 percent this year throughAug. 2 and the ETF version gained about 8.3 percent since itstarted trading in March. Pimco's bond funds on averageoutperformed 59 percent of peers this year through June 30,according to data compiled by Chicago-based Morningstar.

Downswing Protection

Masha Gordon, who joined Pimco from Goldman Sachs, managesthe $519 million Emerging Markets Fund, which fell 22 percent inthe 12 months ended Aug. 2, putting it behind 90 percent of peers.The fund declined 0.5 percent this year, trailing 89 percent ofrivals. The fund uses tail-risk hedging to protect investors fromlosses during extreme volatility.

“In equities, we want to deliver outperformance over thethree-to-five-year period,” Kashkari said. “The common element isprotection, so the funds may give up some upside to protect duringthe downswings.”

Gross, in an August investment outlook published on Pimco'swebsite, said the 6.6 percent real return that stocks producedannually over the past century were the result of a flaw much likethat of a Ponzi scheme. In Ponzi schemes, named after 1920sswindler Charles Ponzi, money from newer investors is typicallyused to pay earlier participants.

If stocks returned almost twice as much as the 3.5 percentannual economic growth over the period, that implies that investorsparticipated disproportionately in the wealth that was beingcreated, at the expense of workers and government, who saw realwages and tax revenue shrink in proportion.

Debt Reduction

With governments forced to reduce their debt, the declinein real wage growth eventually reaching an end and GDP growthslowing, the return rates of stocks will suffer, Gross said. Sowill returns on bonds, for that matter, as yields on long-termTreasuries have fallen to 2.55 percent, he said.

Pimco's two biggest and longest-running equity funds havebeen less volatile than their benchmark indexes. The standarddeviation of return, a measure of price swings, for Pimco EqSPathfinder was about 16 percent over the past year, compared with22 percent for the MSCI World Index, according to data compiled byBloomberg. Pimco EqS Emerging Markets Fund had a standard deviationof return of 25 percent, compared with 27 percent for the MSCIEmerging Markets Index.

Pimco EqS Dividend Fund, started last December, is run byBrad Kinkelaar and Cliff Remily, who joined from ThornburgInvestment Management. The fund, which invests in dividend- payingstocks globally, returned 6.2 percent this year through Aug. 2,trailing 72 percent of rivals.

More Time

The firm opened a fourth equity strategy in April, PimcoEqS Long/Short Fund, which lets clients participate in long-termstock ownership while seeking to limit losses when markets turnbearish by holding cash or selectively betting against securities.The strategy is run by Geoffrey Johnson, who joined Pimco in Aprilfrom Catamount Capital Management LLC, and uses the same investmentprocess as a hedge fund Johnson oversaw since 2003.

“It's going to take more time to see what these managers can dowith these tools at their disposal,” said Anderson of Morningstar.“It could be a hindrance if they're constantly trying to thinkabout this macro view and force stocks in and out based on it.”

Institutional Requirements

One barrier to attracting equity assets for Pimco may be thatinstitutional investors such as pension funds generally require athree-year performance record before they can buy a fund, saidFusion Analytics' Brown.

Pimco is focusing marketing of the funds to its long-termclients first and expects the customer base to eventually be about50 percent retail and 50 percent institutional like the rest of thefirm, Kashkari said.

“We are taking a measured and deliberate approach to groworganically, hire the very best people and integrate them fully andthis is going to take seven to 10 years,” Kashkari said. “We're inthis for the long term and will do whatever it takes to make surethis is a viable part of the business.”

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