2014 3rd Quarter Client Letter

Dear Friends,

Fall is upon us, and of course that means that the National Football League (NFL) has captivated the attentions of many Americans, turning otherwise docile individuals into fanatical defenders of their chosen team. While I am a very casual fan of the NFL (I’m mocked each year within our office because of the mechanical, unemotional approach I take to making my picks in our unofficial football pool), I’m paying slightly more attention this year because of an interesting test that is taking place in both the NFL and the investing world: The challenge of distinguishing true skill from luck.

Over the past three seasons in the NFL, the New England Patriots and the San Francisco 49ers have each been tremendously successful. They have won a combined 76% of their regular-season games and have each made the NFL’s equivalent of the “final four” (their respective conference championship games) for three years in a row. Their coaches, Bill Belichick and Jim Harbaugh, have been lauded as being “geniuses” of their trade. The success of these coaches has also brought notoriety to their team’s respective managements, who have garnered awards for their seemingly excellent executive skills, specifically their decision to hire their respective coaches.

Yet, as of this writing, the 2014 season is four games old and both Belichick and Harbaugh are awash in tough questions, as their teams each have as many losses as wins. Have these coaches “lost their touch”? Are their methods outdated? Have other teams and coaches caught on to their tendencies? Or was their past success just random luck, not the true skill we assumed (or in the case of their fans, hoped) it was? Accordingly, the apparent skill of these teams’ managements is now being pressed by fans and the media: Should their owners do the previously unthinkable and start considering a coaching change? Should they issue some sort of “warning message” to the coach, in hopes that it incents him improve? Or should they “stay the course” under the presumption that the rocky start of the 2014 season is just a short-term aberration?

These are difficult decisions for the management of football teams to make, because it seems very difficult to differentiate luck from skill amongst football coaches. There are countless examples of coaches who have had great multi-year runs of success, followed by not-so-stellar results. In his fabulous book “The Success Equation: Untangling Skill and Luck”, author and academic Michael Mauboussin makes the point that it is easy to ascertain skill in activities where there are few external influences. For example, few would argue against the statement that six-time Olympic gold medalist Usian Bolt is the most skilled sprinter in the world. But in the world of football, where each game is influenced by 22 different players (not counting special teams) on each squad, a bevy of assistant coaches and an unusually-shaped ball that bounces funny, Mauboussin would suggest that luck surely plays a significant role in outcomes.

Many in the investing world have recently been placed in a similar dilemma of having to differentiate luck from skill. The investment media and fund marketers aren’t shy about trumpeting their own “geniuses” and many would put Bill Gross at the top of that heap. Gross founded the bond management firm Pacific Investment Management Co. (PIMCO) in 1971, and grew it to over $2 trillion in assets, constructing a team of over 700 investment professionals along the way1. PIMCO’s flagship fund, PIMCO Total Return, which had Gross’ name attached to it as Portfolio Manager from its inception, doubled in assets under management from 2008-2012, reaching $200 billion. At that time, Total Return was so dominant in the bond world that its assets alone were roughly 10% of the entire taxable bond mutual fund universe. The amazing growth of PIMCO and Gross’ eccentric charm with the media over the past four decades caused Jason Zweig of the Wall Street Journal to state “other than Warren Buffett, Mr. Gross is the most recognizable investor in the world.”2

This notoriety is why much of the investment world was rocked in late September by the news that Gross had decided to leave the firm he founded, and was immediately joining Janus Capital, a relatively unheralded competitor. Gross’ move has left investors in PIMCO’s strategies, from the estimated 28,000 individuals who own Total Return3 to institutions like the Illinois’ state university retirement body, which has $870 million invested with PIMCO4, wondering what do next.

Many of these PIMCO investors are looking to the investment consultants who advise them. Most of these firms are paid on the premise of being able to comb through the universe of tens of thousands of investment managers to find the precious few that their clients should entrust. Of course, in most cases the client believes that following the hire/fire recommendations of these advisors will translate into above-market returns for them, even after the fees they pay to both the advisor and the investment managers recommended by the advisor.

For years, many investment consultants found PIMCO Total Return to be a no-brainer recommendation. After all, the past performance had generally been great; the famed Gross was still PIMCO’s stated leader and he had built a huge team of credentialed professionals around him. But now the consultants, just like the owners of the Patriots and 49ers, are being put to the test as to whether to stay with PIMCO or recommend a change to their clients. I personally spent over a decade of my career as such a consultant and can tell you that situations like PIMCO’s are almost impossible for even an experienced evaluator of investment managers to truly be confident about. Who within PIMCO is truly the ‘skilled resource’ that clients should entrust their money to? It is impossible for an outsider looking in to PIMCO to have a clear perspective on this key question. Supporters of Gross claim he was the creator of the fund’s strategy, was listed as having the overall responsibility for the fund and was the demanding leader that set the tone for the entire organization. Supporters of the ongoing ex-Gross PIMCO organization claim it was impossible for any single individual, even Gross, to truly have his finger on the pulse of a portfolio that, according to Morningstar, contains over 16,000 individual bonds that PIMCO bought and sold very rapidly (227% annual turnover). Thus, they claim, the true “skilled resource” must be some subset of the other 700 investment professionals at PIMCO that contributed to Total Return’s past success.

Exacerbating this challenge is a thought not many traditional investment consultants consider: Maybe PIMCO’s past results weren’t the result of true skill of anyone at the organization – maybe they were just luck. After all, academics have effectively demonstrated that if you put enough monkeys in a room and let them throw darts at the Wall Street Journal, their results will be equal to or better than professional fund managers, and one of them is bound to generate eye-catching long-term results at random.5 6

I wish both the football team owners and the advisors/investors in PIMCO Total Return luck in their respective decisions of what to do next, because it is likely that luck, not prescience, will determine their outcome. Using Mauboussin’s criteria for differentiating skill from luck, trying to beat the market like Gross and PIMCO attempt to do is on the opposite end of the luck-skill spectrum from winning a sprint. The price of a given stock or bond is influenced by the opinions of thousands of well-educated financial market participants, the actions of corporate management teams and even government policy makers. With this multitude of complex variables at work every day, it appears obvious that market-beating results are in most cases just as likely to be luck as true skill.

There is another way to invest that avoids challenging decisions like those facing PIMCO’s investors: Engage only investment managers who employ low-cost, consistent processes that are backed by academic evidence, instead of paying higher costs to invest on the hunches of a purported “star” manager. With these highly-structured investment strategies, your wealth is not married to the success of one individual’s bets on the direction of the markets. Rather, you are simply trying to capture the returns provided by the markets in a very clear, disciplined manner. It’s not as exciting to talk about at cocktail parties or golf outings, but we think it is the most prudent way to accomplish your financial goals.

As always, we are happy to address any comments or questions you might have.


Chuck Carroll, CFA, CAIA

Chief Investment Officer

TFO Phoenix, Inc.
2 ”Should Investors Chase After Bill Gross Again?”, Jason Zweig, The Wall Street Journal, September 26, 2014.
3” Big Pimco Investors: In Search of Redemption?”, Jason Zweig, The Wall Street Journal, October 1, 2014.
4“Critical Time for Pimco, as Pensions Consider Removing Funds in Wake of Bill Gross Departure”, Matthew Goldstein and Landon Thomas Jr., New York Times, September 30, 2014
5 “A Random Walk Down Wall Street”, Burton Malkiel, 1973.
6 “Luck vs. Skill In the Cross-Section of Mutual Fund Returns”, Eugene Fama and Kenneth French, The Journal of Finance, October 2010.