Managing Manager Risk

PIMCO’s star manager, Bill Gross, is moving on to Janus. By some accounts, the Janus brand will be rejuvenated with the arrival of the “bond king,” a moniker earned over a long run of outsized returns in plying the waters of fixed income. But his track record in recent years has looked increasingly wobbly, a familiar strain that tends to arise eventually as the challenge of beating the market rises for everyone through time. The main lesson here, however, is less about quantitative results vs. what might be called manager risk. When your favorite stock picker (or in this case bond picker) abruptly heads for the exit, for whatever reason, dealing with the blowback can be cumbersome.

The departure of Gross is a major news event, in part because of his celebrity status and the billions of dollars subject to his oversight. But the dirty little secret in the world of actively managed mutual funds is that manager changes, and the mess they leave, is a routine part of the game. Quite often the implications of personnel changes borders on irrelevance among the lesser gods in active management. Such non-events raise the question of why investors were paying a premium in higher fees relative to index funds in the first place, but that’s another matter. As for the teachable moment when we heard that Bill Gross has left the building: It’s a reminder that planning for management changes should be standard operating procedure if you own actively run funds.

That’s especially true if you hold a pool of active managers to fill out all your asset allocation. For a slightly more obvious reason these days, it’s prudent to have a Plan B that’s ready to roll if you wake up one morning and learn that one of your ace investors is no longer answering the phone. Egression analysis, as I dubbed it a couple of years ago in piece on manager exits I wrote for Financial Advisor, will likely see a lot of use over a period of time. Unfortunately, there’s no standard procedure for deciding what to do, if anything, as a number of PIMCO investors are learning.

For investors with a chunk of change that was linked to the bond king’s security selection skill, there’s suddenly a lot uncertainty to consider. Some clients apparently anticipated as much and have been pulling assets out of PIMCO for months. The portfolio on which Gross has built his legend—the Total Return mutual fund—has been bleeding money lately, with $222 billion under management at the moment vs. a peak of $293 billion in 2013, according to The Economist. That’s still a huge portfolio, of course, which raises the question of how anyone could have expected spectacular results when managing such a pile of cash?

Such are the questions when chasing star managers. Has he lost his touch? What happens if he leaves? Is the fee too high to justify the odds of earning a market-beating return after adjusting for risk? Such questions are part and parcel of owning actively run funds. The challenge is worth the price tag, say the advocates. If you owned Total Return over the last decade or two, you’d be sitting on handsome gains relative to what a relevant index fund would have dispensed.

Fair enough, but history is always crystal in telling us what we should have done. The question is whether we were savvy enough to hitch our fixed-income allocation to Bill Gross in, say, 1994? Maybe. But picking hot managers in advance is difficult. In fact, the odds of overall success for your asset allocation are even more challenging if you’re trying to choose multiple winners across the major asset classes. The more likely scenario when diving into actively run funds head first: you’ll end up with a mix of winners and funds with mediocre records, and paying for the privilege via fees that, in the aggregate, run substantially above the cost of index funds.

The bigger question: How do you want to run your overall strategy? Looking for star managers has obvious sex appeal. Owning the Total Return fund over the last 20 years still comes with impressive bragging rights. But in a world where diversifying across asset classes and risk factors has become practical and inexpensive, using active managers to execute an asset allocation strategy looks increasingly like state-of-the-art money management a la 1986.

Unless you’re planning on making extreme bets in one or two asset classes, or tilting your portfolio heavily in favor of the next Bill Gross, the expected payoff from traveling down the actively managed path ends up looking a lot like a high-priced indexing strategy. As such, you might want to consider ditching the high fees and keeping the indexing, which you may already own anyway once you consider overall outcome.

In the end, the details on designing and managing asset allocation will dictate most of your portfolio results. Engineering superior outcomes on this front is harder than it sounds, which means that distractions that take you away from this task–egression analysis, for instance–can be costly.