The news that Bill Gross left Pimco stunned the investment world. The man and the organization have been indelibly linked. In fact, the man was the organization as far as most were concerned, a notion that neither Gross nor Pimco went out of their way to dispel.
This could be the start of a cautionary tale that will be played out over the next few months and years, one about the unwinding of an organization dominated by and seemingly dependent on one individual. Of course, Pimco is more than Gross, and the professionals that remain with the firm will have a chance to prove what they can do and to rebuild the firm in a new way.
It is worth remembering that we have seen this soap opera before. Not with the same characters or exactly the same plot, but the same conclusion: If you choose to build an organization based upon a star, you have “key man” risk that can get triggered in short order by an organizational test of wills, the proverbial bus on the loose, or some other unforeseen factor. If you choose to invest with such a firm, that risk comes along for the ride, and, when something happens, you don’t get a call in advance from the portfolio manager, the PR department, or your sales representative.
That said, for clients of Pimco, the immediate question is, “What do we do now?”
But, a more important question is, “How do we select managers?” And it should be asked not just by those investors who are unwitting players in the Pimco drama, but also by those who happened to avoid that particular soap opera.
Predictably, believers in passive management have used the Pimco events to reiterate the difficulty (some would say folly) of trying to pick active managers. The body of evidence supports their claim – and undoubtedly more and more investors will come to the conclusion that the manager selection process is stacked against them, further supporting the trend toward indexation.
For many, that would be a good decision. Asset owners and gatekeepers (advisory firms, consultants, etc.) often have a stated belief in active management that isn’t accompanied by the proper resources or the differential analysis that would be required for success. It doesn’t do any good to have that belief if you can’t capitalize upon it.
This is obviously an issue for most individual investors, and it’s a particular problem for advisory firms, most of whom (in my estimation) do not have sufficient in-house investment staff to devote to understanding asset management organizations. But, as performance studies have shown, even investment consultants, funds-of-funds managers, and large asset owners (all of whom tend to have greater resources and more experience at the process) struggle to add value through manager selection.
So, the takeaway from the soap opera ought to be, “We need to determine if we can select managers well enough to make it worth our while (after hassles and expenses).” To do that, you need to do an in-depth evaluation of the “how” of your due diligence.
Having seen selection processes from throughout the investment world, I believe that most are reactive by design. To see why that is the case, let’s use the simple template of “the four Ps”: philosophy, process, people, and performance.
There really is no way to understand the interplay of those four factors without doing detailed, in-person evaluations. That knocks out most organizations, who can’t afford to do that, unless they use a third-party provider (more on that below). And you can’t just show up (or, as is so often the case, have a relatively junior person show up). Good due diligence requires an approach that goes beyond the conventional norm of a) hearing a manager’s presentation and b) filling out a list of due diligence questions.
Philosophy is a factor that is relatively easy to assess from a distance. The underpinnings of a strategy, at least as it is stated, can be judged in the light of historical experience and economic circumstances.
Whether it is executed in a way that makes sense depends on the manager’s process. But without a direct observation of it, the vision of a manager’s process in your head is the marketing version of the process rather than the process itself. The gap between the two of them accounts for a great many allocation errors.
And then there is the assessment of the people at an organization. Again, without being inside an organization, you don’t have much of a chance of understanding its culture. That certainly has been proven by the Pimco episode; try to find any bad “people” grades in due diligence examinations of it in the past. Most of the time, downgrades of a firm on this attribute come after someone leaves. The change in judgment might be warranted, but it is reactive nonetheless.
Of course, performance is backward-looking and triggers the most powerful and destructive set of reactions. Investors buy past winners and sell losers. Those selecting managers talk about how everything else (especially process) is much more important than performance in their decision making, but that’s simply not true in the vast majority of cases. I often say, “we see performance and infer process,” but really it’s broader than that: We see performance and infer the quality of all attributes of an asset management firm. Performance is a force field that distorts everything (approached in power only by the force field that is a star manager).
If you rely on third parties to do the due diligence on your behalf, you are not immune from these problems, you have just outsourced them (and probably don’t truly understand what has been done on your behalf). Those you hire to do due diligence might do a better job than you would have, but that is not the proper measuring stick.
“We’ve done our due diligence.” That phrase is heard time and again, but what does it really mean? The challenge of due diligence is to take a process that is reactive by nature and remake it into something that is useful. It can’t be done by following an industry standard that has been shown not to work.