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Keeping Watch on Key Man Risk

The biggest story this year in the fund world is that Bond King Bill Gross departed PIMCO in favor of smaller rival Janus (JNS). Gross founded and built PIMCO from the ground up into a nearly $2 trillion mega-investment manager. His own flagship PIMCO Total Return Fund (PTTRX) became a staple in many retirement plans and at one time held a whopping $293 billion in assets.

pimco bill grossThen Gross left amid a tumultuous and crazy year that included weird interviews, an SEC investigation and key personnel changes, including one PIMCO fund manager leaving to start a food truck.

While we will never truly know really why Bill Gross left PIMCO — thanks to various legal gag orders — his departure highlights a specific kind of risk for retail investors. It’s one that many don’t consider at all, whether they are buying a fund manager’s stock or one of its mutual or exchange-traded funds.

We are talking about “Key Man” risk and it can be a serious threat to your money.

PIMCO’s Classic Case of Key Man Risk

For many, Bill Gross was PIMCO and PIMCO was Bill Gross. Sure, there are plenty of other talented investment professionals at the firm. For example, PIMCO’s current chief investment officer, Dan Ivascyn, has actually outperformed Gross over the last few years. But in many investors’ eyes Bill Gross was the essence of PIMCO. They took comfort knowing that if they had money at the firm, they had the Bond King watching over their dollars.

When Gross jumped ship — from the firm and his Total Return Fund — that relationship was broken. As such, billions in assets have flown the coop.

Investors yanked nearly $27.5 billion from PIMCO’s flagship Total Return Fund in October. That follows $23.5 billion worth of investor withdrawals in September. Meanwhile, news continue to hit the wires that a multitude of institutional investors, pension funds and retirement account sponsors have begun examining their relationships with PIMCO. The flagship Total Return fund is being dropped in spades from many 401(k) retirement accounts.

All in all, PIMCO saw a 5% asset drop across its funds during the third quarter. And it’s all because Bill Gross left PIMCO.

Each year investors allocate billions of dollars to mutual funds, ETFs and hedge funds headed by a “superstar” manager. The problem is we believe that the “superstar” –- who is driving the fund’s performance and growth in assets under management — will always be there. Remember, investment management is mostly about brain power. By owning the Total Return fund, you were betting on Bill Gross’s ability to navigate the bond market successfully.

Some investors have turned to bond superstar Jeffrey Gundlach at DoubleLine as an alternative. But what if he gets eaten by a bear while camping? All joking aside, that’s a serious problem if you’re an investor in Gundlach’s DoubleLine Total Return Bond Fund (DLTNX).

Beware of Asset Flight

The main reason to worry about key man risk is because it exposes the fund to asset flight. When customers sell, that can force the fund manager to sell underlying assets inopportune times. It might mean an equity fund manager is forced to sell a stock that has the potential to move higher. For fixed-income funds, it could mean a manager has book a loss in a bond that was delivering a decent yield. These sales can have serious tax implications.

For investment management firms, asset flights can mean reduced earnings, dwindling share prices and, in some cases, complete closure.

Bill Gross leaving PIMCO isn’t the only recent example of key man risk. Invesco (IVZ) saw huge outflows when top-performing fund manager Neil Woodford unexpectedly left its U.K. office earlier this year to start his own asset management firm. Back in 2011, hedge fund Highbridge Capital was forced to completely close its Asian Investment Fund — at a huge loss — when its regional head jumped ship.

What Do About Key Man Risk

My advice? For starters, don’t bet big on superstar managers. There’s plenty of evidence anyway that many fund managers can’t keep that outperforming their benchmarks for the long haul anyway — mostly due to asset bloat. Even Gross was suffering under the huge size of PTTAX the last few years. Indexing continues to eat active management’s lunch.

Not to belittle anyone’s skills, but if Michael Buek, who is the manager of the Vanguard S&P 500 Index Fund (VFINX), gets abducted by Martians, VFINX will be perfectly fine. You can’t say that about Gundlach and DoubleLine. If you invest with superstars, keep the allocation small.

Second, you may want to avoid publicly traded stocks of investment managers with large key man risks. While many of these firms do carry insurance on their superstars, the coverage doesn’t necessarily compensate for the damage to the brand and future asset growth. Two I have concerns about are GAMCO Investors (GBL) and Franklin Resources Inc. (BEN).

GBL has a high dose of key man risk in that its founder Mario Gabelli is GAMCO. Like Gross, Gabelli is the main driver and manager of the most of GBL’s funds and products. Morningstar said it best about GBL: “The firm is completely based on the cult of personality of Mario Gabelli.” At 71, Gabelli is getting up there in age.

While Franklin’s bench is deeper, it does have pretty considerable key man risk in  Michael Hasenstab and Mark Mobius. Hasenstab is considered to be the third place bond guru — behind Gundlach and Gross. As such, he commands billions of assets at BEN across a multitude of platforms. As for Mobius, he basically invented emerging markets investing and manages billions for BEN. Losing either of these guys would be a huge loss for the stock.

The Bottom Line: Bill Gross’s departure from PIMCO can serve as a very important lesson for investors. Key man risk is often something we don’t think about until it’s too late. It’s an important issue to consider when evaluating your portfolio.

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