How important are changes to a portfolio’s management line-up? The intuitive answer is ‘very.’ But recent research by Morningstar has suggested this may not be the case.
The report, called The Aftermath of Fund Management Change, examined the effect of any manager leaving or joining a fund, with its scope not limited to lead managers.
In the US actively managed equity and fixed-income space, there has been an average of 244 such moves per month since January 2003, the research found.
The study looked at the performance of portfolios over one, three, six, 12 and 36 months, and examined historical correlations between fund management characteristics and subsequent gross excess returns and growth rates.
It defined a number of variables, of which four related to management change, and measured the average change in gross excess returns and flows over each period, given a one-unit increase in each variable.
It found that there was no relationship between any type of manager change and future portfolio returns.
The authors, Morningstar quantitative analyst Madison Sargis and director of quantitative research Kai Chang, wrote: ‘A management change is not predictive of a performance downturn. In fact, there is zero relationship between a management change and future returns over the next month up to the next three years.
‘Furthermore, this holds true for all different types of management changes. Gross excess performance does not depend on the fund’s alpha, size, or industry experience at the time of management change.’
The study found investors nonetheless typically reacted by withdrawing money from funds following manager moves, although they gave top performing funds the benefit of the doubt, selling off at a slower pace.
Devil in the detail
Gatekeepers gave the research a mixed reception.
They supported many of the paper's conclusions, saying it highlighted some valuable lessons for retail investors about the rationale for picking a fund, the importance of not panicking and the growth of team-based management. According to Morningstar, only 25% of funds in the US are now run by a single manager.
However, gatekeepers also argued that the overall conclusion reached by the paper was too broad, partly as a result of the number and type of manager moves included in the data. Greg Maddox, head of global manager research at Wells Fargo Investment Institute, said: ‘We don’t know from the Morningstar study which PM is changing. In so many of these team-led things, you could have a co-PM who wasn’t as instrumental to the process resign, you could have a junior PM take another opportunity somewhere else. That shows up in the prospectuses as a PM change. So that’s all being captured in the data.’
Amy Magnotta (pictured above), head of discretionary portfolios at Brinker Capital, agreed. ‘In the paper, they took any manager change, so it could be a more junior manager on the team, which may not be as big of a deal as a key co-PM,’ she said.
Maddox (pictured below) added: ‘They are lumping all those changes together and coming out with a general view on that. I think directionally, the general view is probably right. However, we don’t think you can just default to that. So the lessons they are conveying to investors are probably oversimplified and could potentially do more harm in very specific cases.’
When star managers matter
He gave the example of Bill Gross leaving Pimco, a move that resulted in investors withdrawing hundreds of billions of dollars from the firm’s then-flagship Total Return fund over the next two years. Maddox said Wells did not issue a ‘sell’ on the fund, however.
‘We knew what we were buying and why we were buying it [and] we weren’t buying it solely because of Bill Gross,’ he said.
‘We didn’t predicate our investment thesis entirely on Gross. That’s a shop where they’ve got a bunch of sector analysts that are feeding the ideas to the PMs and that has been institutionalized.’
‘His approach is a little bit different from Bill’s,’ Maddox said. ‘I mean he’s actually getting involved personally, negotiating with foreign governments around workouts on some of the bonds he’s owned and access to certain bonds.
Magnotta added: ‘In the situation where the analyst team is driving a lot of the ideas or the process, I think those can withstand a manager change. But if it’s a key person that’s driving the strategy, whether or not they are supported by a team of portfolio managers, they are the vision for the strategy and how they position the portfolios. I think that’s where the manager change could affect performance.’
Mark Sloss, chief executive of Regenerative Investment Strategies and a partner at RIA Wilde Capital Management (pictured below), said that the rise of team management in some cases disguised the importance of one or two individuals to a fund’s performance.
‘I think the storytelling has got more team-oriented, [but] I don’t think necessarily that there are percentage-wise many more purely diversified teams as opposed to individuals. I haven’t seen that,’ he said. ‘“Team-based” is usually a rhetorical game fund companies play to avoid having to sticker or reprint prospectuses when the named PM leaves.
‘Back in my days working for a mutual fund company, I specifically remember there were efforts to try to keep the characterization of the portfolio management team and the prospectuses as broad as possible.’
One reason fund groups did this was to avoid the kind of investor reactions the Morningstar report highlights. But the swelling of such teams means that there are also a large number of appointments and exits to funds that may not be material to performance.
While Maddox acknowledged that the study looked at multiple time frames, he questioned whether the fact that the periods studied coincided with rising markets might have an effect on the findings.
‘I think it’s a short period of time, and they did a good job trying to adjust for that,’ he said. ‘They did acknowledge that it’s difficult to know when to actually start the clock to evaluate it. Furthermore, and maybe this is a little bit too much in the weeds, but through much of that time period we had a rising market too. I have to think through selling into a rising market, think what carrying cash would mean for underperforming managers.
‘I think [Morningstar] probably would benefit by looking at this phenomenon over different time periods, different time frames to see how that plays out. With any of this stuff, the more data points and more observations you have, the more confidence you have.
‘I guess my confidence would go up if we see longer periods for the study.’
While generally agreeing that investors should not rush out the door the moment a change takes place within the management of a fund, gatekeepers said the report only considered quantitative factors and ignored other reasons for investing in a fund or with a specific manager.
‘By its nature, judging the importance of a manager change is a qualitative exercise,’ said Tim Paulin, senior vice-president of investment research and product management at Touchstone Investments (pictured below).
‘The importance of a manager change and a client's rationale for terminating the fund will be impacted by the type of strategy, the role of the manager, the depth of the team and so on,’ he said. ‘Short-term excess return is as likely to be impacted by asset class, style and factors being in or out of favor as it would by manager security selection,’ Paulin added.
Quality not qualitative
Some strategies, such as quant funds, may be entirely process-driven and require no human judgment, while other strategies may be highly subjective, he said.
‘I would think any fiduciary would quickly come to the conclusion that a major management change makes them uncertain about the rationale to maintain the fund – irrespective of how good the past performance is,’ he said.
‘I doubt those fiduciaries would take solace in Morningstar’s research and conclude that they might as well hold on because research says that funds, on average, perform just as well after a manager change as before it. [The fiduciaries] don’t care about the averages; they care about their own money and it’s not invested in the average of all funds.’
Co-author Sargis (pictured below) said the report was clear that it took a quantitative approach and the conclusions were based on data. ‘The study was not conducted qualitatively,’ she said. ‘The study took a quantitative perspective and examined correlations. It looks at what typically happens. And typically, nothing happens.
‘We identify the month a manager change occurred and then look at the relationship between forward gross excess returns and growth rates. It is certainly true that some funds have worse returns after a management change.
‘But our study finds that it is equally likely that they have better returns following a management change. Hence the finding of no correlation. It is this data that forms the basis for our conclusion that the average fund is not affected by management change.’
She said the study had excluded funds labelled as index strategies, to screen for quant offerings, and backed the report’s overall findings.
‘It’s true that some quant strategies may not be marked as index funds and therefore could have been included,’ she said. ‘Certainly, there are cases where an investor is justified to leave a fund following a manager change – such as a change in strategy. This could be something that our analysis might be missing as this is hard to track. However, these situations are generally uncommon.’
Food for thought
Overall, gatekeepers said that the report highlighted some behavioral biases and that these could be avoided if fund buyers have a proper thesis for owning a particular strategy.
Maddox said the report laid out some important lessons for investors.
‘I think it highlights some time-tested principles that institutional investors are certainly aware of and that retail investors should be reminded of. And that is, you’ve got to know not only what you own, but just as importantly, why you own it,’ he said. ‘Because if you have a thesis for why you own it and that thesis is impacted, then you need to look at that more closely. If your thesis isn’t more predicated on the person, then I think the Morningstar findings are right, you don’t need to make a hasty change.’
Sloss agreed. ‘If this report tells me anything, it’s that gatekeepers and analysts have the responsibility to go deep and do a lot more work on the implications of personnel changes,’ he said. ‘You can’t take the lazy approach and make sweeping assumptions about any managed investment. Is the change material and does it undermine the original reasoning for owning the fund? Could it in fact be positive and reinforcing that a change was made? You’ve got to do the fundamental work.’