Bond king Bill Gross suddenly talking up stocks

Bill Gross, who runs the world's biggest mutual fund, has a confession.

Bill Gross, who runs the world’s biggest mutual fund, has a confession. The Pimco co-founder says he regrets the decisions that doomed the firm’s experiment with equities in the mid-1980s.

He recalls strategy meetings in that era at which Mr. Gross’s bond traders overwhelmed the firm’s handful of equity managers, shooting down their bullish arguments promoting stocks. With limited freedom to pursue their own ideas, the equity managers quit after about two years.

“Those sessions basically said, “Hey, we’re a bond shop. This is what we’re going to do. It’s the party line,’” Mr. Gross, 66, said. “If I’ve been a problem, then I can be the solution in terms of allowing equity investments to grow and prosper.”

Pacific Investment Management Co. LLC, which has been synonymous with bonds for almost four decades, is taking another run at equities. It may not be the most propitious time to plunge into stocks. Volatility, as measured by the Chicago Board Options Exchange Volatility Index, was at a 14-month high in late May as the sovereign-debt crisis swept through Europe.

Driving Pimco’s move into stocks is chief executive Mohamed El-Erian, who with Mr. Gross has promulgated a theory that the economy is going though a period of fundamental transformation they call the “new normal.”

Mr. El-Erian said mounting deficits and tighter financial regulation will dampen growth in the U.S. and the eurozone for the next three to five years. Emerging-markets nations such as Brazil and China, with stable levels of government debt and expanding middle classes, should continue to thrive, he said.

In the new normal, investors will be faced with anemic returns, and they’ll seek alternatives, said Mr. El-Erian, who’s embracing several new asset classes. In the past year, he’s presided over the creation of an equity mutual fund and a unit to invest in hedge, real estate and buyout funds. Pimco has also started 10 exchange-traded funds.

“We are living through a remarkable time of change,” said Mr. El-Erian, 51, who shares the title of chief investment officer with Mr. Gross. “We want to make sure we navigate the changes for our clients.”

Not everyone agrees with Pimco’s analysis. Some cabinet officials and securities analysts said the “new normal” theory is off the mark.

More than 2,000 forecasters estimate that the Standard & Poor’s 500 will jump 26% in the 12-month period through May 2011 as corporate profits rise, according to data compiled by Bloomberg.

Some investors said the firm might be better off sticking to what it knows best. Mr. Gross’s flagship Pimco Total Return Fund (PTTAX), using a complex concoction of bonds, futures and credit default swaps, has outperformed 97% of its fixed-income rivals during the past decade.

“When a fund company expands into new business lines, I get very nervous,” says Martin Weil, whose firm, MW Investment Strategy Group Inc., manages $30 million, much of it in Pimco funds. “I have a very high degree of respect for Pimco. Am I going to dive into their equity offerings? No, but I’ll take a look.”

The three-decade rally in bonds, the very securities that made Mr. Gross famous, eventually will fizzle out, according to Pimco’s outlook. Mr. Gross said the rally will come to an end as nations sell record amounts of debt to fund their deficits, spurring a return of inflation and rising interest rates.

The king of bonds is now talking up stocks as a better long-term investment. He says that as U.S. Treasury returns fall, investors will have to take more risk with high-yield bonds, equities and eventually real estate.

“If you’re talking about the next 10, 15, 20 years, there’s certainly the recognition that assets will grow faster in those categories,” he said. “Over the long term, stocks return more than bonds when appropriately priced at the beginning of an investment period.”

Mr. Gross’s prophecy on bonds may not be coming true anytime soon. Since May, when he warned that European nations such as Greece can’t rely on growth to finance their soaring deficits and would likely default, investors have poured into U.S. Treasuries.

Spearheading Pimco’s push into equities is EqS Pathfinder (PTHWX), a global fund the firm launched in April that buys undervalued securities, mainly in Europe. Its only U.S.-based holding in the top 10 positions is SPDR Gold Trust, an ETF that buys gold. Most of Pathfinder’s major positions — British American Tobacco PLC, food maker Groupe Danone SA and The Link Real Estate Investment Trust — derive at least part of their earnings from emerging markets.

Pathfinder, which has attracted more than $500 million, declined 1.7% in the one-month period ended June 7, beating 96% of its peers.