Thousands of investment professionals gathered at McCormick Place in Chicago earlier this summer for the annual Morningstar Conference. The room had a definitive buzz to it at lunchtime. Bill Gross was the keynote lunch speaker and everyone was patiently waiting to see what he would have to say after stories, rumors and gossip swirled from the departure of his number two and supposed successor at PIMCO, Mohamed El-Erian.
My table was discussing the organizational culture and performance issues at PIMCO that led to huge outflows from Gross’ Total Return Fund. A few people raised some red flags and said they would be hard-pressed to keep client money in the fund. It had nothing to do with Gross as an investor, but the possible headaches that could arise from the headline risk and having to continually answer client questions on the matter. It’s hard enough dealing with the usual noise in the markets.
One gentleman at our table listened quietly as we went back and forth on Gross and what effect it would have on current investors in the fund. He finally entered the conversation and said he was a financial advisor that had invested client assets in the fund for a number of years. He’d been taking calls from clients for weeks and had talked them all off the ledge from selling the fund, saying his PIMCO rep has assured his firm everything was fine. He said he was confident in Gross and the firm’s process.
After Gross gave his now infamous talk (see my earlier thoughts) the advisor looked visibly shaken. He quickly exited the table while the rest of us tried to digest what we had just witnessed.
Each time something like this happens I store it away in my mental notebook of possible changes in the asset management industry. Maybe something, usually nothing, but enough anecdotes like this strung together can start to change the mindset of industry participants.
The abrupt exit by Gross from PIMCO this last Friday followed these earlier rumblings of issues within the firm and it was a shock, to say the least, to everyone from the fund’s investors to industry experts.
Another story that’s been getting plenty of attention lately is the CALPERS decision to end their hedge fund program. According to the New York Times, one of their hedge funds was down 67% in 2013 (I have no idea how this is possible when the market was up 30%+ but that’s another story). I don’t see this having a huge effect immediately, but it will definitely lead to discussions within other pension funds.
The running theme here is an increase in headline risk and the ramifications it can have on the way people and organizations invest. Headline risk should have nothing to do with the portfolio management process, but you can’t simply ignore these stories when they can lead to portfolio manager turnover or asset allocation changes. Once headline turns into career risk, change tends to occur.
To me, these stories could mark the beginning of the end of an era — that of picking a handful of star managers to build a portfolio around. I’m not suggesting a complete shift right away from actively managed funds by any means, but things are slowly heading in another direction from the way active funds are currently structured. I’m not going for hyperbole by suggesting a sudden paradigm shift or a groundbreaking end of an era marked by Bill Gross exiting PIMCO. You can’t turn the battleship around that fast.
But the fund options available to build a portfolio are now deeper than ever. In the past, it was basically active portfolio managers or very basic index funds. Most financial advisors or consultants would market their services to clients as “We have a superior process to be able to judge this portfolio manager’s process. You don’t have the time, expertise, budget or know how to perform this due diligence but we do. We’ll pick third-party managers for your portfolio.”
Now costs are coming down at a rapid rate. ETFs, smart beta, factor investing and quant models now make it easier than ever to for the public at large to invest in what were once complicated strategies available to a select few wealthy investors. And you can do it at a fraction of the cost. There are only so many ways to slice and dice these things, but I believe the innovation and cost-effectiveness of these products is only going to get better from here on out.
This is a great thing for individual investors. But it could (and should) cause some disruptions in the way that advisors and consultants market their services. The manager-of-managers approach is never going to completely go away. There will always be a select group of professionals that can pull this off, but the majority of the manager-of-manager teams will have to alter their approach to justify their fees.
If I’m right, the era of superstar mutual fund managers will make way for the asset allocation era. More and more portfolios will be driven by multiple streams of cheap risk factors, beta, sectors, asset classes, and quantitative strategies. Investment professionals will need to prove their worth through risk management techniques, asset allocation models, financial planning, education, and client communication.
It will be much harder for advisors to justify their due diligence costs when you can buy a broadly diversified ETF or mutual fund at a fraction of the cost that has no eccentric star manager to deal with. No one has ever written an exposé about an ETF. There’s no need to visit the physical office or run background checks on the portfolio managers (yes, this happens).
Most investment managers, consultants, and advisors should have been focusing more on these areas of portfolio management in the past anyway. Eventually many will have no choice as clients won’t be as trusting of their process of evaluating someone else’s process when problems still slip through the cracks.
This has nothing to do with the active versus passive debate as active strategies will continue to get cheaper in the future. Dirt cheap portfolios will make asset allocation and behavioral control more important than ever. It also doesn’t mean there won’t be any active managers that will outperform the market or become stars. That’s never going away. It’s just that the reliance on a superstar manager as a core portfolio holding from all corners of the industry will start to wane.
Jerry Seinfeld once said that breaking up with someone is like tipping over a pop machine — you have to get it rocking back and forth a few times (breaking up & getting back together a number of times) before it finally falls over. This is how attitudes and investment styles change in the finance industry. It takes time. Nothing happens overnight.
I don’t believe in tipping points when so many people have vested interests in the status quo. Changing behavior is hard, for investors and asset allocators alike.
But investors have been losing faith in the system for a number of years now. The financial crisis and Bernie Madoff got the ball rolling. Many portfolio managers who were seen as untouchable before the crisis were exposed during the crash and its aftermath.
The greatest bond fund manager of all-time just jumped ship from one of the biggest mutual funds on the planet on a Friday and starts a new role at a new firm on the following Monday. This series of events still absolutely boggles my mind.
How will this affect the trust investors place in the hands of star portfolio managers?
We shall see. Maybe I’m overreacting.
But I sense Bill Gross gave the pop machine a solid shove. It could take a while but I think eventually it tips over.