What to Do If Your Fund Changes Portfolio Managers

Stay the Course If your fund manager dies tomorrow, you really shouldn't care.

Such is the conclusion reached in Morningstar's new white paper, "The Aftermath of Fund Management Change," although the authors (Madison Sargis and Kai Chang) don't phrase the matter that way. Rather more politely, they write, "We find no relationship between any type of [fund] management change and future returns."

No argument here. At the start of 2014, with PIMCO's reputation in tatters after the departure of chief investment officer Mohammed El-Erian and (accurate) rumors that manager Bill Gross might soon follow, this column ran the headline, "PIMCO Total Return: Not Fussing." The story, it continued, "is messier than the investment results will be."

My thinking ran along these lines:

1. Investors worried that this performance might slip another notch, because of both the fund's managerial turmoil and because the fund would suffer losses while selling securities to meet redemptions.
2. Those concerns seemed unlikely. PIMCO had dozens of experienced investment professionals, and most of its holdings were very liquid, so they could easily be traded without roiling the markets.
3. What's more, because of the glare of publicity, PIMCO was unlikely to take major chances with the fund. It would be run relatively cautiously to deliver returns that didn't stray far from the norm.

One point for Rekenthaler! (Then subtract one for this botched article, which predicted that a fund company's legal settlement would be the first of many. Totally wrong. It turned out to be a single, isolated case.) Since that column was published, PIMCO Total Return has matched both the intermediate-bond Morningstar Category norm and its benchmark. For the most part, investors who bailed from PIMCO Total Return to buy another intermediate-bond fund would have landed in the same place.

Of course, I didn't know any of that when writing the column. PIMCO Total Return might have suddenly returned to its previous glory, rendering my diagnosis of "not fussing" inadequate. Or it could have continued its slide. The best I could do was play the odds. Those odds suggested that, while the fund might improve dramatically or might prolong its relative losing streak, the likeliest possibility lay somewhere in the middle. That El-Erian left and Gross might do the same was news, but the news didn't appear to be actionable.

Sell Now, Ask Questions Later And yet many investors do take action. The other main finding of the aftermath paper is that, on average, investors penalize funds after portfolio-management changes. All else being equal, funds that undergo such changes sell fewer new shares during the next three years than funds that don't. The figures are not huge, but they are statistically significant, and, as one of the authors reminds me, "the amounts might not seem important to you, but I bet they are to those fund companies."

I bet that, too.

The authors conclude from the evidence that fund shareholders "overreact" to fund-manager changes. While I won't quite go that far--such a conclusion rests on several reasonable but unproven assumptions that the paper does not test--I think it's fair to say that investors believe that they glean more information from portfolio manager changes than they actually can.

Mixed Signals The implication, of course, is not that investment managers don't matter. They certainly do. If the fund has but one portfolio manager--increasingly uncommon in this era of team management--that person bears complete responsibility for the fund's results. A swap at the top will directly alter the bottom line. If the fund has multiple managers, the effect is lessened, but that departing manager ran something. The fund will not be the same as before.

Will the change be for better or worse? Therein lies the challenge. Portfolio manager results are so noisy that even apparently skillful managers might have just been lucky during their tenures, and apparently poor managers may have been insightful but unfortunate. Thus, it doesn't necessarily follow that a good fund that loses its star manager has nowhere to go but down, and a bad fund that fires its dud must surely improve.

If it is challenging to assess the former manager's abilities, then it borders on impossible to forecast the new manager's. Most incoming managers have no published track records, and even if they have, it's perilous to read much into them. Aside from the confusion caused by the aforementioned noise, there's also the danger of assuming that what succeeded (or failed) at one fund will do so at another. Portfolio mandates differ, fund sizes differ, incoming cash flows differ.

Alright, I confess: This column's first sentence was exaggerated. You certainly should care if your fund's portfolio manager were to die; failing to do so so would be inhumane. What's more, that fund might have additional circumstances that lend more information to the decision. The authors find, for example, that funds that combine poor performance, declining assets, and a manager change are also likely to be merged out of existence. It might be wise to head for the exit before that occurs.

Think twice, however, before acting. The apparent bad news is probably not as bad as it first seems, nor the good news as good. That is the message delivered by "The Aftermath of Fund Management Change."

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.