The Watch List: A Useless Contrivance
At the beginning of this year Mohamed El-Erian, chief executive officer and co-CIO, announced his resignation from PIMCO. I wrote about the pressures that might have motivated Mr. El-Erian to depart (“Moving Parts at PIMCO” January 24, 2014). The financial press continues to report about the outflows from PIMCO’s Total Return Fund and Bill Gross’s efforts to reassure investors. Of course, PIMCO doesn’t just manage mutual funds; it also has an enormous business managing separate accounts for large institutions.
What are those institutions doing about the management changes and apparent corporate tumult at PIMCO? Do their consultants have any advice? At this point, the answer seems to be: watch list. When an institution isn’t sure what it wants to do about a money manager, it sticks the manager in the investment equivalent of a penalty box. Unlike hockey, where the penalty is determined upfront, in money management the institutional investor only decides after a couple of months whether to let the money manager return to the ice or banish him to the dressing room.
Typically money managers wind up on the watch list for two reasons: either their performance has lagged, or there’s been some major change at the money management firm. In either instance, the watch list is a pretty useless device and only increases the risk to the institutional investor and subjects them to enhanced politicking from the money manager. A recent article from Reuters demonstrates how investors use the watch list to demonstrate that they are doing something when, in fact, they aren’t doing much about a failing money manager.
For consultants, the watch list can serve a useful purpose. They can use the device to show their clients that they are applying enhanced scrutiny to a manager while waiting to see if their clients decide to fire the manager. In other words, the watch list can help a consultant avoid getting ahead of their clients.
If performance has lagged, placing the manager on the watch list only encourages the manager to take more risk in the short-run. Knowing that his days are numbered and he may lose the mandate in the next three to six months, the manager might as well try to gamble a bit more in the portfolio in the hopes of creating better short-term performance. As it is, too many money managers are really traders. The watch list encourages them to be speculators.
If the money manager has sold his business, been hit with a regulatory infraction, or suffered a management change, most institutional investors will send him to the penalty box. While it makes obvious sense for the investor to gather basic information about pending matter, placing the manager on the watch list only results in a series of highly stilted meetings, while the manager works his political connections in the background.
When the investor meets with the money manager, the money manager will tell the investor that he remains focused on investing and is excited about the prospects for the markets and his business (exactly what Mr. Gross has been telling investors). He will tell the investor that the new owner, new executives, and/or new systems will enable the money manager to do a better job in the future. If the problem involved compliance or regulatory matters, it won’t happen again.
Whether it’s performance-related or corporate change, the placement on the watch list will get the manager to feverishly work key trustees at the pension plan or endowment in order to slow down the evaluation process or build pressure to restore the manager to normal status. There’s very little that’s productive about this process.
If the performance has lagged significantly over a meaningful period of time, it’s probably best to banish the manager rather than placing him on the watch list. If the manager is selling his business, it’s usually advisable to terminate the relationship. If the portfolio manager is leaving, and the firm doesn’t have a true team approach or a well-groomed successor, it’s time to fire the manager. In my view, it’s the compliance and regulatory red flags that require some study. Some violations may be rather technical or very distant from the portfolio manager and the investor’s mandate. In other instances, the transgression may be serious or be part of a more pervasive pattern. The former can probably be forgiven; the latter, in all likelihood, will warrant dismissal.
Only two things are certain in the coming months. PIMCO’s senior executives are either going to be in endless meetings in their offices in Newport Beach, or they’re going to be in the conference rooms of their clients.