Minimizing Manager Risk

Bill Gross' sudden departure from PIMCO in September threw the investment world for a loop. Given that  PIMCO Total Return (PTTRX) is one of the most widely held actively managed funds, financial advisors, plan sponsors, and individual and institutional investors alike had to decide whether to stay the course with the fund or bail. It appears that not a few are heading for the exits: Investors pulled roughly $23.5 billion out of the fund in the month of September according to PIMCO, the bulk of which presumably came in the days after Gross' exit.

Putting the melodrama of the PIMCO/Gross saga aside, the abruptness of Gross' departure has brought to the fore manager risk--that is, a risk that the loss of a portfolio manager fundamentally changes an active fund's merits. Investors in actively managed funds know it's impossible to avoid manager risk altogether, but there are plenty of reasons to try to minimize it. For one, it can be a time and resource drain for investors. Importantly, it can force them to make a tough call at a moment's notice, with all the attendant risk of making a hasty decision to go with what has worked--i.e., funds boasting strong recent performance--rather than what will work.

With those concerns in mind, we thought it would be useful to delve into how to evaluate and minimize manager risk based on our experience managing active portfolios for clients.

Firm Culture Is Key
We believe understanding a firm's culture is paramount to predicting stability in its ranks. A firm's culture is difficult to assess at any one point in time, but rather is a mosaic that you have to piece together over time through iterative, in-depth diligence. That research should yield answers to questions like whether the firm is primarily focused on investing rather than asset-gathering and if portfolio managers have enough skin in the game through fund ownership or compensation practices that promote investor success.

Fortunately, we're able to draw on a deep, broad body of research in this vein: Morningstar's Parent ratings. Indeed, for a number of years Morningstar's analysts have been evaluating factors such as manager incentives, fees, regulatory history, board quality, and corporate culture in determining whether a firm has proven to be a good steward of investors' capital over the long term. That assessment culminates in the Parent rating of positive, neutral, or negative, which, in turn, feeds into the qualitative ratings the analysts assign to every fund they cover. Given that firm culture figures heavily into each Parent rating, it stands to reason that the ratings can serve as good proxies for culture across Morningstar's rated universe, and we can, therefore, assess the relationship between a firm's culture and stability. As of Dec. 31, 2013, Morningstar had assigned a Parent rating to 179 mutual fund companies.

There are ways we can quantify whether a firm has historically succeeded in retaining and nurturing investment professionals, a hallmark of any stable investment organization. For example, firm retention rate measures the percentage of a firm's portfolio managers that stayed with it during a particular timeframe, and firm average tenure indicates the average tenure of the longest-serving managers across the firm's funds. By comparing these data points to the firm's Parent rating, we can derive a clearer sense of whether there's a strong link between firm culture and manager stability.

To that end, the exhibit below assesses firm retention rate and average manager tenure by Parent rating. As shown, there's evidence of a strong relationship between a firm's Parent rating and manager retention and tenure. That is, in Morningstar's judgment, healthier firm cultures tend to boast stability in their ranks, which in turn likely helps to reinforce and sustain the most worthwhile aspects of the culture in a kind of virtuous cycle. By partnering with firms like these, we believe we're less likely to encounter abrupt manager turnover in the portfolios we manage, thereby mitigating manager risk.

That raises the question of whether assessing PIMCO's culture in recent months could have signaled Gross' impending departure. Indeed, PIMCO had experienced several senior-level departures over the past several years, most recently and notably the sudden resignation of CEO and co-CIO Mohamed El-Erian in January 2014. The firm has always maintained a very strong and deep bench of investment talent that allayed the concerns over any single departure, but Morningstar lowered PIMCO's Parent rating to neutral in the wake of El-Erian's departure, due in part to concerns about firm culture and additional uncertainty that comes with personnel disruption. That might have tipped off investors to additional departures in the future.

Still, it's not clear that one could have predicted Gross' departure. In fact, it took almost everyone by surprise. That underscores an important point: Culture might indicate how prone a firm is to personnel flux, but it's not going to tell you if a particular portfolio manager is likelier to leave the fold. And that, in turn, is why it's critical to augment research of firm culture with other analysis, like how well a firm has contingency planned for a portfolio manager's departure.

Planning for Succession
We think that firms that conduct thoughtful, transparent succession planning can help provide continuity even in the event of an unexpected manager departure. Some firms, such as Dodge & Cox, T. Rowe Price, and Artisan Investment Partners, are exemplars in this regard. Dodge & Cox operates in an investment committee structure, which reduces the impact of any single manager departing. Artisan Investment Partners requires that portfolio managers signal their intention to retire three years before ultimately leaving the firm. For example, Scott Satterwhite, who manages several Artisan funds including  Artisan Small Cap Value , announced in 2013 that he'll retire at the end of September 2016, giving the firm ample time for succession plan and affording investors the chance to weigh the implications. While T. Rowe Price has experienced some surprise departures more recently, historically the firm has given fundholders advance notice of manager changes and employed long transition periods to promote continuity.

All three of those firms receive high marks within Morningstar's Stewardship Grade framework. Contrast that with PIMCO, whose disinclination to talk about life after Gross arguably made his abrupt departure that much more disruptive. Gross had no handpicked successor, and leadership had not signaled which senior investment professionals might be in-line to take the reins. In other words, Gross' exit left a vacuum, forcing clients to think on their feet.

Assuming Key Manager Risk--Now What?
To be sure, there will be funds where it might be a worthwhile tradeoff to assume some key manager risk, whether it's Michael Hasenstab at  Templeton Global Bond (TPINX) or Jeffrey Gundlach at DoubleLine, to name a few prominent examples. In these instances, what's the right calculus for determining whether the potential reward more than justifies that risk?

In our practice, we ask ourselves a few questions. For one, is the fund providing something unique? In addition, is the manager financially motivated--via high levels of ownership of fund shares, deferred compensation practices, and equity ownership--to stick around? In cases where the manager has put up terrific numbers but it's a me-too strategy or there's seemingly little to tie him to the firm, we'd be leery. But if it's a well-niched discipline and the manager is the owner/operator, that's a different story.

There are also often different gradations of manager risk to consider. You may be less worried about the departure of a star manager at a run-of-the-mill equity strategy versus a portfolio manager whose style is less imitable. Marty Whitman of Third Avenue comes to mind here; Whitman served as the lead portfolio manager on  Third Avenue Value (TAVFX) for more than 20 years before stepping down in 2012. The portfolio was oftentimes eclectic and concentrated, and Whitman employed a fairly distinctive balance-sheet-style value approach, producing superior results and an ardent following during his tenure. Despite the fact that Whitman had named an heir apparent and built a long-tenured analyst team, the fund was still very much a reflection of Whitman himself, which complicates succession to say the least. In situations like these, it's important to have a contingency plan--a deep bench of viable candidates to replace the fund in the event that key-man risk, or other issues, becomes too great to overcome.

Another key factor to weigh is whether, as a researcher, you can go deep enough to understand the process and how it's implemented. And that, in turn, is likely to somewhat depend on the star-manager's accessibility. If the manager is very forthcoming, this is likely to confer a better understanding of what makes the strategy what it is. (That also explains, to a certain extent, why so many investors bailed on PIMCO Total Return, as their research probably didn't go much deeper than the name on the door, Bill Gross.)

Worth the Time
Some investors will find this whole exercise of identifying talented managers and mitigating key man risk as pointless. To be sure, for those disinclined to commit the time needed to conduct thorough diligence, or who simply doubt the staying power of star managers, indexing is the way to go. For those devoted to active management, however, there are benefits to managing the people risks in portfolios. It pays to invest with strong stewards of capital, be weary of firms that scoff at questions around succession, and be cognizant of the key-manager risk in portfolios

This article originally appeared in the December/January 2015 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.

Michelle Ward, CFA, is an investment manager, managed portfolios, with Morningstar Investment Management.

The opinions expressed herein are those of Morningstar Investment Services, are as of the date written and are subject to change without notice, do not constitute investment advice and are provided solely for informational purposes.

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