The recent news that Pimco’s Mohamed El-Erian is leaving the firm is yet another reminder that active money management comes with its own set of particular risks—risks that are easily dispatched with index funds. As The Telegraphobserved earlier this month: “While the jury is out on what prompted Mr El-Erian’s sudden exit, one thing is certain: the world’s largest bond fund has just lost one of its most influential and formidable investors.”
One of the advantages of holding a mix of index funds is avoiding this type of disruption. Well-designed index products are largely immune to the ever-changing lineup of personnel at fund companies. Instead, the goal is delivering the specific market beta, cleanly and inexpensively, regardless of who inhabits the front office at the moment. Advocates of actively managed funds say that Pimco is a big shop and it has the resources to replace El-Erian with an equivalent talent. Maybe so, but there’s no guarantee. At the very least, the potential for manager departures is a risk factor for active funds—and one that you can avoid entirely by sticking with index funds in an asset allocation plan.
Assuming that you own a diversified mix of active funds, you’ll probably see several managers head for the exits over the years. That leaves you with a future of deciding, several times, if you should sell the affected fund or hold on. Even if you make great decisions, you’re not adding value–rather, you’re simply maintaining continuity, and that’s the best-case scenario.
In any case, don’t underestimate the work involved to develop a high level of confidence that you’re making the right choice. A couple of years ago I wrote an article in Financial Advisor magazine that reviewed the implications of manager exits and the takeaway is that these events are going to dump a fair amount of analysis in your lap. “There are no hard and fast rules for evaluating management changes, simply because every situation is different and the future’s always unclear.”
Even under the best of circumstances, the departure of a manager is a distraction from the critical work of managing the asset mix. In the long run, portfolio results are driven by two key factors: the selection of assets/asset classes and how/when to rebalance. This is hard enough without adding extra work. Sure, you may be able to juice the outcome a bit by picking talented managers, but the inevitable exits will complicate the process.
Is the extra work worth it? Generally speaking, no. Investors as a rule have a hard enough time making superior asset allocation and rebalancing decisions, as a number of studies show. Using active funds adds another layer of complexity, and for reasons that go well beyond manager exits.
Yes, you may be that rare individual who makes informed decisions about departing managers. But that’s the exception. For most of us, using a mix of index funds can help focus our attention on crucial issues that we can’t afford to muck up. Chasing star managers, by contrast, is an unnecessary and potentially costly diversion.
But let’s be fair and recognize that you may have a favorite manager or two. Fine, but holding a portfolio with, say, a dozen active funds is probably a short cut to high-priced mediocrity, or worse. The odds, in short, are definitely not in your favor when you go overboard with active funds in an attempt to beat Mr. Market’s asset allocation.
This piece is cross-posted from The Capital Spectator with permission.