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Bill Gross, Star Managers and Risk

October 16, 2014

For RIAs, Bill Gross’s departure from Pimco is more than just a story about a legend’s fall from grace. It’s a learning moment about risk management, due diligence and financial advisors’ proper role vis-à-vis their clients.

The bad news for advisors invested in the so-called Bond King’s former fund is they’re knee-deep in fallout. Gross’s Pimco Total Return Fund had a record $23.5 billion in redemptions in September, leaving assets hovering just below $200 billion, according to Sept. 30 Morningstar data.

The worst may be yet to come.

The mistake most advisors make when they invest with star managers is believing in them too fervently. When that happens, advisors often channel too much client money to a single manager. Assuming an allocation of 60% in equities and 40% in fixed income, overweighting any fixed-income fund is a bigger liability than many investors signed up for.

Typically, a portfolio’s equity portion is spread across many asset classes and managers. With fixed income, however, there is a narrower range of options. Thus, advisors may be more inclined to put a fixed-income allocation in just a few places.

It’s easy to see why a disproportionate amount of capital went to Gross. He delivered outperformance for many years. But that also created complacency.

Many believed there was no reason to invest elsewhere. However, that defies the cardinal rule of investing: Very few managers can beat the market over the long term. Efficient markets are ruthless, and returns eventually revert to the mean.

When the news broke of Gross’s split with Pimco, advisors faced a double whammy. They had a bigger allocation in one fund than was probably prudent, and the entire investment thesis for being in that fund vanished instantly. As many of us know, life’s valuable lessons are usually learned when something goes wrong. In that spirit, advisors might be wise to consider the following before investing with a celebrity portfolio manager.

First, acknowledge that doing so carries real risk. It may be an acceptable choice in terms of reward, but it also concentrates risk — which it’s an advisor’s job to manage.

Second, a team approach to fund management based on enduring investment principles is a sound long-term strategy. A team may not be as brilliant as an individual manager, and it may be subject to group-think — but it does reduce professional risk.

Third, advisors must remain extremely vigilant about manager selection and monitoring. Systematic due diligence around money managers is essential. This is the boring spadework of the business, but it’s the reason clients engage with you in the first place. Ultimately, investors need to trust their advisors to select good managers and to keep an eye on them.

Fourth, don’t ignore signs that trouble lies ahead. When Mohamed El-Erian, Gross’s heir apparent, suddenly left the firm, it should have raised a big red flag. In contrast, think about the well-executed transition from Fidelity Magellan fund manager Peter Lynch to successor Jeff Vinik. As a result of the smooth transfer, Lynch’s departure was felt over the long term, not the short term.

An orderly transition lets advisors have productive, positive conversations with clients. By contrast, Gross’s sudden defection forced advisors to fumble around, trying to explain why they didn’t see trouble around the bend.

The bottom line is that investing in a star manager is much like the prisoner’s dilemma. Advisors put themselves in a position of having to live and die by the sword. The problem is, many don’t realize they are making that decision.