Frustrated Worker

Yet Another Problem with Active Investing: Manager Turnover

Frustrated Worker

The surprise exit of Bill Gross from PIMCO likely has scores of investment committee members scratching their heads, wondering how to handle their fixed income mandates.

Gross had fostered a stunning reputation for active bond management, racking up more than 26 years at the helm of PIMCO’s Total Return fund -- a fund that ultimately burgeoned to more than $293 billion. During his tenure, he enjoyed the title of “Bond King” and relished in being the “go-to guru” for actively managed bond funds. 

By his own admission, Gross’s success, along with other legendary investors he names, was more a function of being in the right place at the right time.

“All of us, even the old guys like Buffett, Soros, Fuss, yeah — me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch, than an investor could experience… Perhaps, however, it was the epoch that made the man as opposed to the man that made the epoch.” 

Well, that epoch chapter has drawn to a close for Gross, punctuated by calls that missed the mark, sixteen months of negative fund flows, and reports of intolerable and erratic behavior.

So, investment committees are faced with a decision. Do they follow Gross to his new home at the Janus “Global Unconstrained” fund? Not so fast. At just $13 million, this fund is but a puff of air compared to PIMCO’s behemoth fund — certainly not an apples-for-apples exchange, creating more than a slight shift in asset class style that will not be easily reconciled in the investment policy statements.  


Should you stay or should you go now?

Gross’s big name made for a very public parting from PIMCO. But, manager turnover is actually quite common. Crystal balls turn cloudy more often than not, and managers move on -- willingly or otherwise. So, instead of questioning whether to follow Gross, stay with PIMCO, or find another active manager, committees may do well to pause and question the process of active manager selection altogether.

In a landmark study called “The Selection and Termination of Investment Management Firms by Plan Sponsors,” academics Goyal and Wahal dug into the success of the manager selection and termination process. They looked at 8,755 investment manager hiring decisions, along with their pre- and post-hiring returns, and determined that “the termination and selection of investment managers is an exercise that is costly to plan beneficiaries."

The chart below depicts the study’s findings.  As shown in the blue bars, on average, managers with above-benchmark returns in the three years before hiring delivered below-benchmark returns in the three years post-hiring (See this in-depth analysis). And, in a separate study looking at a subset of that same data, with the returns of 660 managers they tracked post-firing—as shown in the yellow bars--the managers hired to replace the fired managers actually underperformed them. In other words, the fired beat the hired.

The results of this study may come as little surprise to investment committees who have long pondered how they hire managers with winning records just in time for them to lose. It is as Gross himself acknowledges—markets make managers.

“Charles Ellis’s recent piece in the Financial Analysts Journal  (written about here) tells us that “despite considerable time and access to managers’ data, the self-chosen task of the investment consultant firms has proved far more difficult than expected. As a group,” he cites, “selection consultants have caused their clients to underperform by 1.1%, according to a working academic paper titled: “Picking Winners? Investment Consultants’ Recommendations of Fund Managers.”

On page 17 of "An Experienced View on Markets and Investing," Eugene Fama, Nobel Prize winner in Economics and highly regarded “Father of Modern Finance,” puts it plainly: “Active management is a zero-sum game — before costs…even the top performers are expected to be only about as good as a low-cost passive index fund. The other 97% can be expected to do worse.” And, if that wasn’t poignant enough, Fama also declared, “An investor doesn’t have a prayer of picking a manager that can deliver true alpha. Even over a 20-year period, the past performance of an actively managed fund has a ton of random noise that makes it difficult, if not impossible, to distinguish luck from skill.”  

Calpers, the country’s largest pension plan has figured it out. Last year, their committee voted to move their defined-contribution plan to an all-passive offering. And, in September 2014, the pension fund elected to divest itself of all of its hedge fund investments, effectively firing the managers who collectively held more than $4 billion in active management mandates. “At the end of the day, judged against their complexity, cost, and the lack of ability to scale at Calpers’ size,” the hedge fund investment program “is no longer warranted,” according to NY Times. Stories like these go a long way in explaining why a TIME magazine article declared “The Triumph of Index Funds.”

Revelations brought to bear by Calpers, along with a wealth of unbiased academic research and mainstream media alike, clearly reveal the failure of active management to deliver on the promise of outperformance – so much sizzle, and yet, no steak.

For investment committees, there is no time like the present to embrace index investing. Index investing is not only a viable, low-cost alternative to the crazy-making behavior induced by performance chasing, it is the superior alternative.