Gross and net returns

THE departure of Bill Gross, the world’s best known bond manager, from PIMCO, the investment firm he helped to found, has many potential lessons. At its simplest, it can be portrayed as a Shakespearean drama; the ageing king who refused to loosen his grip on power. Eventually, his subordinates rebelled and overthrew him.

PIMCO’s other titan, Mohamed el-Erian, departed earlier this year, prompting a reorganisation of the management team. The next generation of leaders wanted to expand in new areas, something Mr Gross apparently resisted. The Securities and Exchange Commission, an American regulator, recently announced an investigation into pricing at the Total Return fund, the main outlet for Mr Gross’s talents, creating the potential for damage to his reputation. Mr Gross ostensibly moved to Janus, a smaller fund manager, to focus more on investment and less on management, but he clearly jumped before he was pushed. The lesson could be that founders are rarely good at succession planning; they often stay in place too long.

A second lesson concerns whether investment firms are wise to rely on the reputation of a “star” fund manager. At its peak, the Total Return fund had assets of $290 billion, a good chunk of PIMCO’s $2 trillion total. Mr Gross’s occasionally eccentric pronouncements (he once devoted a section of his newsletter to the death of his pet cat) were avidly watched by other investors.

In recent years, he has made some big calls on the bond market. Four years ago, he talked of the British bond market resting on a bed of nitroglycerine; three years ago, he worried that yields would rise when the Federal Reserve ended its second round of quantitative easing. Neither bearish bet on bonds paid off and the Total Return fund suffered a slump in performance; its return is below the average for similar bond funds over the past five years.

In the short term, PIMCO may be damaged as clients follow Mr Gross to Janus. But the Total Return fund was already suffering outflows because of its faltering performance. In the long run, PIMCO may benefit if clients are drawn more by the strength of its team, and less by the abilities of an individual. Analysing the global bond markets, with their many different countries, currencies, maturities and credit ratings is not a one-man job.

The third lesson is for investors: beware big funds if they are actively managed. If a large bond fund is to beat the market (and justify its fees), the manager probably has to make some big bets on the economy. This is not the same thing as finding a few neglected companies, whose bonds are undervalued because investors have overlooked a crucial fact. Fund managers have no advantage in predicting the economic outlook; indeed, most economists failed to foresee the recession in 2008.

The “big fund” problem previously emerged at Fidelity, where its Magellan equity fund rose to prominence under manager Peter Lynch. After he left in 1990, the fund underperformed the S&P 500 in 12 of the next 20 years, although it did not reach its peak size of $110 billion until 2000. It has since shrunk to $17 billion.

This is a perennial issue. When fund managers perform well, they attract clients and the fund gets bigger. Eventually, however, the fund will stumble. There are three possible reasons for a reversion to the mean. First, the initial strong performance was down to luck, not skill. Second, the initial performance was due to a trend, such as rising technology stocks or falling interest rates (which boost bond prices); eventually, the trend changes. Third, the manager will struggle to excel as the fund grows bigger, perhaps because it has to invest in the shares of bigger companies, or because it must buy more liquid assets; eventually the fund starts to resemble the index.

When performance falters, money will exit again. Thus, in what might be called the Sod’s law of fund management, a fund’s worst year will probably occur when it is at its biggest. The last clients to jump on the bandwagon will be those who earn the weakest returns.

The same rules do not apply to passive funds, which explicitly try to match the index. In those cases, a bigger fund should lead to economies of scale which can be passed on to clients in lower fees. But the expense ratio of 0.46% on the Total Return fund translates into costs of $1 billion a year at its current size. According to Morningstar, an agency that rates funds, this charge “is a lot more than one might expect given [its] size”. Investors are betting big on PIMCO’s ability to beat the market.

^{Economist.com/blogs/buttonwood}