Giving Key

Key Man Risk: Yet Another Reason to Avoid Active Funds

Giving Key

When discussing the risks of investing in actively managed funds, we have focused on issues related to timing and selection.  Recently, we had a chance to view a report from a prominent investment consultant that was prepared for a major institutional client in Southern California. We were a bit puzzled to see an entire page of the report dedicated to “Key Man Risk” which was basically a list of the active fund Companies recommended by the consultant with various individuals designated as key men (yes, they were all males). The word that kept recurring in this list was “concerned” as it related to how deeply concerned they would be if one of the key men were to leave. We are quite certain that if PIMCO Total Return had been one of their recommended funds, we would have seen Bill Gross designated as a key man.

This list prompted us to think about the question of why an institution (or a retail investor for that matter) would want to stake their future on the talent and supposed market-beating ability of one person. Frankly, we just cannot come up with a viable justification. Maybe we have studied market history a little too much and are all too familiar with cautionary tales like Bill Miller (who beat the S&P 500 Index for fifteen consecutive years only to blow up) or Bruce Berkowitz (who was named Morningstar’s Fund Manager of the Decade in 2010 only to lag his benchmark by a stunning 34.5% in 2011).

When it comes to investing, we maintain that the most important thing is the process, and if the process is sound and properly executed, key man risk should not be an issue. Of course, people have to be involved in designing the process and modifying it, as needed. However, the organizing principles that underlie the process should be widely dispersed within the company. We know this to be the case for Dimensional Fund Advisors where we have spent a great deal of time attending their educational programs for advisors.

Investors in passively managed asset class funds (or index funds) know that if their fund manager gets hit by a bus, the fund will continue to get the return of its targeted asset class. It is our opinion that consultants who are paid to identify the key men or key women should be doing something more productive with their time and their client’s money.