A recent analysis published by Morningstar shows that, on average, there is generally speaking no appreciable change in future performance expectations following a fund-management change; yet, investors commonly overreact and pull money from these funds.
The findings suggest that the fund industry “handles succession planning far better than investors react to such changes.” When it comes to defined contribution plans, the analysis finds, this phenomenon is partly driven by the fact that plan sponsor decisionmaking is often tightly controlled by an investment policy statement (IPS) prescribing certain actions that must be taken when specific triggers are met.
As demonstrated by the latest PLANSPONSOR DC Plan Benchmarking Survey, 65% of all plans manage their investment exposures according to a formal, written investment policy statement. This figure jumps to 88% for plans with more than $100 million invested, showing that the significant majority of DC retirement plan assets are invested according to the tenants of an IPS. While investment policy statements are far from standardized, the research shows many mention in some capacity the plan’s general objectives and investment structure/criteria. Further outlined will be the ongoing investment monitoring and evaluation processes, and often a fund manager personnel change serves as a trigger, leading the plan sponsor to put a fund with a recent manager change onto a watch list. Once on a watch list, it may only take one or two quarters of slightly below-benchmark returns to lead to a funds’ potentially disruptive dismissal.
The Morningstar research shows this widespread approach is probably not necessary and in fact may be counterproductive from the standpoint of maximizing returns. The research finds “no relationship between any type of management change and future returns.” In fact, the highest-performing funds are those “given the benefit of the doubt by investors” when there is a management change or another transitory issue. Interestingly, it seems to be only the largest brand-name funds which experience substantial outflows when there is a manager change, but the loss of the fund manager’s industry experience seems to have no effect on either returns or growth rates in the longer term.
For context, readers may recall the situation in 2014 when Bill Gross unceremoniously exited PIMCO. At that time sources told PLANSPONSOR the subsequent months of moderate outflows from PIMCO in no way resembled a true threat to the sustainability of the business or the ability of the management teams to continue to meet performance goals. Yet many plan sponsors put their PIMCO funds on watch, including funds that both were and were not directly managed by Gross. It is true that $23 billion flooded out of the flagship Total Return Fund Gross managed within a month of his departure, but over the longer term there proved to be no protracted mass exodus impacting other funds sold by the firm. In fact, many advisers attributed some of the subsequent challenges faced by the firm more to the fact that former CEO and co-CIO Mohamed El-Erian left the business, and to Gross’s own behavior in that unique situation—described by some at the time as vengeful and even erratic.
Indeed, Gross was listed as lead portfolio manager on 18 funds, but there were also strong day-to-day portfolio management teams in place on all of the funds. Thus, little likely changed in the real management effort of those funds—a fact borne out by the performance profile of PIMCO investments today compared with earlier times when Gross remained at the helm.
And so it is only natural that plan sponsors should reconsider to what extent their IPS includes specific requirements around a manager change. Offering some thoughts on the proper role of an investment policy statement, Jim Phillips, president of Retirement Resources, and Patrick McGinn, vice president of Retirement Resources, suggest as a rule of thumb, sponsors should be very careful about the use of “shall,” “must,” and “will” statements. These types of statements in the IPS, whether applying to situations involving manager changes or anything else, paint the sponsor into a corner and unnecessarily increase liabilities. The better approach is to “include just enough structure to be able to demonstrate you actually have a prudent process by which the plan’s investment menu will be managed.”
The Morningstar research is candid that the firm “has had a history of being skeptical of management changes, putting funds on watch lists.”
“From our study, we find that we do not need to downgrade a fund every time there is a management change if we feel confident in the parent, the fund’s process, and finally the cost,” the analysis states. “However, we do need to identify the cases when there is a policy change in the fund’s strategy versus simply a management change, and alert investors of such cases. We need to do this because we find on average, most management change cases result in business as usual at the fund.”
The analysis suggests that it is much more sensible to adopt an approach for monitoring manager changes (whether or not formalized in an IPS) that strives first and foremost to identify if the change represents a true policy modification or simply a shift in transitory personnel. Changes in the former camp likely do warrant a fund being placed on a watch list, given the Morningstar findings on performance and flow stability, while those in the latter camp probably do not warrant watch-list consideration.
Fred Reish, chair of the Financial Services ERISA team at the law firm of Drinker, Biddle and Reath, urges plan sponsors to remember the IPS “is the committee’s document; you own it.”
“Make sure it’s what you want. There aren’t any required provisions. It is there to help you, not hurt you,” he warns. If plan sponsors have doubts about their IPS and what it may force them to do in a situation such as a manager change, they can change the IPS to say that its provisions are intended to provide guidance and to help with consistency for committee decisions but are not binding on the committee.
“Review the IPS once a year, and go through it item by item, to make sure the committee is following its terms and that it covers all the investment decisions that need to be made. Committees are most often sued for the decisions they do not make—or, in other words, the issues they do not pay attention to,” Reish concludes. “Make sure the agendas for your meetings list the decisions your IPS says the committee must make. And make sure that all of the necessary investment decisions are in the IPS—such as expenses, share classes, revenue sharing, quality of investment management, asset classes, company stock, brokerage accounts and so on.”