Summary

• Investors should know the pitfalls of active fixed-income funds.
• Why investors should consider low-turnover bond funds.
• How active funds have, as a whole, failed investors.

Bill Gross, the manager of the largest bond fund in the world, has abruptly left the firm that he co-founded 43 years ago and that is nearly synonymous with his name: Pacific Investment Management Co.-PIMCO. The firm manages about $2 trillion and Gross’s Total Return Fund alone has $222 billion. The fund also comes in an ETF version (SYMBOL: BOND ). Gross also managed the PIMCO Corporate & Income Opportunities Fund, a closed-end fund (SYMBOL: PTY ).

There are perhaps more individual shareholders of the Total Return Fund than any other actively managed bond fund. In fact, I suspect that many of you reading this article today actually own this fund in your retirement accounts. (Check those statements!) Now that he is leaving after a stretch of poor investment performance, what are investors to do?

Before starting my own firm here in Coronado in 2002 I actually worked for PIMCO as an analyst and co-portfolio manager (on the equities side, however, not fixed income). I am thus quite familiar with the company, its fund offerings and how it operates.

Gross’s resignation, however, presents no problem for us here at Orion: since our founding in 2002 we have never bought for any client a single share of any PIMCO bond fund. Why? Because, in our view, it doesn’t make sense to do so. The fees for PIMCO funds, in our opinion, are way too high, leaving too little on the table for the investor. Turnover (buying and selling) is also very high within PIMCO funds (and most other actively-managed funds) adding a further tier of unpredictable cost and tax burden. Investors that use mutual funds to get exposure to the bond market are much better off getting this exposure through highly diversified, low-cost, low-turnover funds such as those offered by State Street, Dimensional Fund Advisors, iShares, or Vanguard.

But the reasons we have not invested in the PIMCO Total Return Fund actually extend to the entire industry of actively managed mutual funds, both for bonds and stocks. Except for a few rare instances, we have committed virtually no client money to actively managed mutual funds in our 12-year history. On a whole, active funds are overpriced, tax-inefficient and offer poor investment performance to boot.

While at PIMCO I saw firsthand why the active mutual fund industry has largely failed investors. Fund flows are particularly damaging. Because many investors chase returns, funds that are doing well receive the vast majority of new money. (These are the only funds the marketing folks can sell.) Meanwhile, the funds that are not doing well receive a steady flow of redemptions, forcing the manager to liquidate positions at unfavorable prices. What ends up happening is that the fund manager with the good (recent) track record does not have enough brilliant new ideas into which to deploy the torrent of new money, and the fund’s investment returns head quickly toward mediocrity. Because money tends to pour into funds that have just had excellent recent performance, winning funds often turn into losers just after they get a bunch of new money and investors.

By the way, this is also why investing with funds that have achieved a Five-Star (or similar) rating by firms and newsletters that monitor the fund industry does not work. Almost every manager has a good run from time to time (and a bad run as well). Why begin investing with a manager right after he or she has just had a phenomenal run and received industry accolades for it? Such a manager will probably be contending with large cash inflows that will very likely water down future performance. and probably be due for a sub-par stretch of performance as well.

For detailed analysis of why active mutual funds don’t work, see this article ; there is an intriguing part about A Case of Disappearing Funds and very interesting analysis about how winning funds perform subsequent to their anointment as winners.

As usual, I welcome your comments and feedback.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.