Sell Gross, Buy El-Erian? I'll Take The Other Side Of That Trade

by: Jim Sloan

In a February 25 SA piece, "It's Time For Bill Gross to Retire," Felix Salmon jumped on the WSJ piece by Greg Zuckerman about the infighting at Pimco between Bill Gross and Mohamed El-Erian which led to the departure of El-Erian to "write a book." Both articles took a negative view of Gross. Salmon extended the argument to suggest that it was time for Gross to depart. I beg to differ.

I have never met either of the principals. I have never owned a fund managed by either. I have seen them in action only as talking heads on CNBC. I have, however, read their pieces on the Pimco web site going back, probably, fifteen years in the case of Gross, roughly the same in the case of El-Erian except for the period when he was away on a brief gig running the Harvard Endowment. I have tracked their funds and considered their points of view. Here's my take on the two men.

Gross created modern bond fund management. He pioneered the idea that total return was more important than coupon payments as the measure of performance for a bond portfolio. He pioneered many of the ways of measuring risk and reward for different types of bonds. He applied these concepts with persistent success over the long bond bull market, in both up years and the occasional down year in the bond market. He understood early, a little too early, that the great bond bull market was over, but he has been creative in devising strategies to use for one's fixed income allocation in the post-bull bond market.

El-Erian has written interestingly and thoughtfully on emerging market bonds and managed a fund successfully. He was not, however, a pioneer of method or theory. Emerging market bond investing isn't rocket science. It comes down to never forgetting that Argentina (to choose a model) is going to default and make a mess of naive investors every six or seven years and get religion on fiscal integrity when the situation is sufficiently horrible about once a generation, providing nice bond returns for four or five years if you manage to be one of the early ones out the door. Five or ten emerging countries are even worse than Argentina. The rest are a little better. A handful, mainly in Asia, are bootstrapping their way out of the emerging stage. El-Erian knew this, reminded his readers periodically, got the timing mostly right, and prospered. He gets credit for noticing in the early 2000s that emerging markets actually looked sounder than the U.S. did. It was a true insight at that moment.

The kind of bond management Gross does is rocket science. It's a game for guys with street smarts, poker-playing skills, and math. Gross has all three, along with the ability to invent new things, admit mistakes, and change his view when the facts change.

What are they like as human beings? Gross is actually a poker player, good enough to pay his bills with it as a kid. He is also able to come to terms with lots of quantitative info and make solid summary judgments most of the time. Bond guys are the smartest guys in the financial world. If you have been around for thirty or forty years you know that. Bond guys know the mean streets and the math. If you regularly take alpha out of them, you are pretty damn good. Gross did. It's a lot harder in the QE-driven markets of recent years, but he still does pretty well playing a truly terrible hand. If he were a horse (now running on a sloppy track), he would be Secretariat.

El-Erian is a suit.

Happily for us, both men have written a book. I read both of them when they came out and gave them both another quick scan yesterday. Let's have a look at them.

El-Erian: When Markets Collide

I bought the hard cover to read on a flight to Dubai in December of 2008 while the world was coming unstuck. He seemed to be writing on that subject. A few pages into it I started watching chic-flics and thrillers with my wife, but I had paid cash money for the book so I made myself read it while sleepless with jet lag. Holy Moses! Have you ever plowed through an IMF report? El-Erian worked there, you know. Instead of executing Saddam Hussein we should have strapped him to a chair while someone read this book aloud to him over and over for thirty years.

When I taught fiction writing, I made students do a study of the number of Germanic/Anglo Saxon words versus the number of complex Latinate words in an English text. Hemingway, for instance, hardly ever uses a word that originated in Latin or Norman French. Multi-syllabic Latinate words are used freely by people who have nothing to say, who want to hide what they are saying, who are pretentious beyond belief, or who are lawyers - or any combo of the above. You know the stuff that goes in small print on packaged food products and financial ads? The word is boilerplate. El-Erian's book is written in boilerplate. I couldn't recall a single clear idea from it, and my quick reexamination didn't come up with one.

Here's a sentence (on "noise" in the markets): "This bumpy process is nothing less than a collision of markets, in which the markets of yesterday collide with those of tomorrow." Come to think of it, this may be the theme of the book. It must be. If anybody can tell me how this sentence added to their knowledge of anything, help me please. Another quality of this book: second-handedness. Signal versus noise was a meme whose time had come a couple of years before El-Erian wrote, as had behavioral economics and black swans, two other notions which El-Erian explores at second hand in the book, almost as if to say he had been keeping up with financial blogs. Where were the ideas? Maybe I am unfair. Have a look for yourself.

What El-Erians's book contains is institutional wisdom, a watered down kind of thinking to start with which is watered down further for the unwashed - think of the occasionally effective but always predictable and often obtuse IMF. This isn't surprising as El-Erian is an institutional man. This is clear in his reverent mention of Harvard president Drew Faust stunning the audience at her inauguration with the startling insight that "in facing the future, universities must embrace the unsettling change that is fundamental to every advance in understanding." (In the interest of full disclosure I must admit that I am a Harvard grad and get bombarded with Harvard-think in Harvard-prose in every edition of Harvard Magazine, which in true contrarian fashion I take as evidence never to give them money.) El-Erian looked exactly like what Harvard wanted for its endowment after they ran off Jack Meyer, but he left after discovering that he lacked the sharp elbows to deal with Larry Summers. Summers, like Gross, is a smart guy with a big ego, sometimes wrong but always armed with lots of knowledge and intellectual artillery, and not a fool-sufferer.

In fairness: El-Erian was a much better writer and thinker in his earlier Pimco pieces when he was an emerging bond manager. I used his pieces on emerging markets as a starting point. I want to be fair about this. I just think he got out of his range of competence when he left the world of emerging market bonds.

Gross: Everything You've Heard About Investing Is Wrong

I found this an interesting piece of writing at the time and still find it interesting today. It is written in a folksy style that I recognize. It is the style of a down-to-earth guy who is plenty smart and who knows that if people understood how hard-driving and judgmental he is, they wouldn't like him. He tries to sound nicer and folksier than he is. That's fine with me. I understand the problem.

The basic message of the book was that the era of the great bull market in stocks and bonds from 1982 until the time of publication (1997) was ending. The future was going to be an era of 6% returns at best. To improve on it was going to require a basket of little tricks, and you were not going to improve on it much.

Taking the long view, Gross was right and right and right. What he didn't anticipate was the path to that kind of net return and the way bond yields would be driven down, giving a last gasp of significant total return. He was a bond guy. The kind of insanity stock guys were about to go through over the next couple of years was way off to the side in his peripheral vision. Bond people are generally rational, and he probably couldn't believe people were as dumb as they were about to be - twice. The two crashes and recoveries were a roller coaster which happened in a world that wasn't his. He was doing fine anyway. In any case his estimate of net returns for financial assets going forward was pretty close.

Read the Gross book. If you don't know why you might sometimes buy GNMAs for the small yield advantage despite the fact that portfolio duration always moves in exactly the wrong direction when rates change, he'll explain to you about weighing risks and rewards in terms a novice can understand. He will also explain riding down the yield curve, and you will understand it even if you have never bought a bond in your life. He was also early on demographics, pointing out the implications before the subject became trendy.

The end of the great bond bull has made Gross's life much more difficult. Attempting to outperform in the current environment involves gaming contingent and unpredictable actions (by the Fed, among others). These contingent actions make mistakes virtually unavoidable. Gross has made a few. He still does quite well, however. The really good bond guys all resemble Gross, all two of them, Gundlach and Dan Fuss (in his own down-home cracker-barrel way). They are street guys who would also beat you both at poker and at solving math problems. The contrast with El-Erian is clear.

Conclusion

I'm sure El-Erian is not a bad guy. I'm also sure he is unexceptional, except for political skills and skill at looking the part. I'm also sure that the days of Bill Gross as the major force at Pimco are numbered. There's simply the age thing. It's too bad. I don't think it has to do with any loss of skill, but he is about to enter an age group which violates expectations for an institutional money manager. I also think that Mohamed El-Erian was probably not the right choice as Pimco overlord. They needed someone in the mold of Larry Fink, someone who has actual hands-on knowledge of big-picture financial management. El-Erian's experience was in a narrow part of money management and the larger institutional world of looking the part.

I admit that I have a special empathy for Gross, who is exactly my age, served in the military at the same time I was in Vietnam, emerged with a complicated view of the world pretty much like mine, and who is, deep down, a rebel. I'm sure he just hates the act of putting on a tie. He isn't really the kind of person who could focus mainly on building assets under management. He's a guy who liked to test his exceptional brain against the markets, found he could add alpha in the most difficult part of it, and incidentally built a fortune and a huge money-managing empire. Isn't adding alpha the main thing? I still read his pieces very carefully, and I am fairly sure that his estimate of future returns in all markets, which is quite low, is going to be borne out. If he fades from view, I will miss him.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.