Not just one crown, but three.

Photographer: George Silk/The LIFE Images Collection/Getty Images

How Pimco Lost Its Mojo

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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Why did Pacific Investment Management Co. recently lose its crown as the world’s largest bond mutual fund to Vanguard’s Total Bond Market index fund? The answer might be very deep. 

Financial economists -- and many pundits -- are always telling you that you can’t beat the market. Any time you think you know something the market doesn’t, you’re wrong and the market is right. This is loosely known as the Efficient Markets Hypothesis. This hypothesis also extends to professional money managers and to your ability to pick a money manager who will outperform. Any anomalies will be random. 

But what about those superstar managers you read about in the news, who beat the market year after year? They might be inclined to laugh at Efficient Markets theory. Berkshire Hathaway’s Charles Munger had this to say back in 2003:

For a long time there was a Nobel Prize-winning economist who explained Berkshire Hathaway’s success as follows:

First, he said Berkshire beat the market in common stock investing through one sigma of luck, because nobody could beat the market except by luck. This hard-form version of efficient market theory was taught in most schools of economics at the time. People were taught that nobody could beat the market. Next the professor went to two sigmas, and three sigmas, and four sigmas, and when he finally got to six sigmas of luck, people were laughing so hard he stopped doing it.

So maybe the Efficient Market purists have been mugged by reality. It looks like you can pick a winning money manager -- just go for one with a great long-term performance record. 

Of course, you may run into the problem that the superstar manager charges you such a high fee that he gets to keep all the profit. But there’s another big downside to chasing performance. Strategies that work for a small amount of assets under management, or AUM, may not work for a large amount of AUM. 

This isn't too hard to imagine. For example, a stock picker might be able to use his method to identify 10 underpriced companies, but not 100. Once he invests in those first 10, their price goes up, and they’re no longer underpriced. If his AUM suddenly goes way up, he won’t be able to do what he did before. His return will drift back toward the market average. 

Almost any manager’s strategy is vulnerable to this sort of thing. A manager who uses powerful computers and mathematical models to exploit short-term predictabilities in price movements (statistical arbitrage) will see his transaction costs rise as he takes bigger and bigger positions against the anomaly. A manager who invests in distressed companies will find that the number of distressed companies that want his investment isn't infinite. And so on. Eventually, almost any manager will see his alpha (outperformance) run out as his AUM goes up and up.

This idea was explained in a seminal 2004 paper by Jonathan Berk, then of the University of California-Berkeley, and Carnegie Mellon’s Richard Green, called “Mutual Fund Flows and Performance in Rational Markets.” If you don’t know this paper, you really should. 

The basic model is this: Money managers start out with only a small amount of AUM. Bad money managers, whose strategies fail, leave the market (though new ones arrive to take their place). Good money managers, whose strategies beat the market, keep beating the market until observers realize how good they are. The observers -- investors -- then keep putting money into the good funds. But since even the best funds’ strategies don’t scale up infinitely, this reduces the performance of the good funds over time. 

So in this model, the Efficient Markets Hypothesis isn't right; fund managers can beat the market consistently (although less and less as they manage more money). In fact, the average fund manager will beat the market consistently, before fees. But when the funds are young and small, investors don’t know which ones are the market-beaters. And as the successful funds grow, investors flock to them until they stop beating the market. 

So if Berk and Green are right -- and they find various pieces of evidence that fit their theory -- it has big implications for you and me. It means that chasing performance won’t pay off. We might as well go with passive funds, like those offered by Vanguard. 

This brings us back to Pimco and Vanguard. Pimco outperformed for many years, and money kept flowing into the fund. But as the fund grew to monstrous size, the performance of superstar bond king Bill Gross began to lag. It might be that “Secretariat,” as Gross famously named himself, couldn’t keep winning races with so many people riding on his back. Eventually, disappointing performance was followed by outflows, and Gross left.

So now Vanguard is the king. But Vanguard’s fund is just a robot that tracks the index. Maybe investors are beginning to realize that chasing superstar performance is a losing game for everyone but the superstar himself.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Noah Smith at nsmith150@bloomberg.net

To contact the editor on this story:
James Greiff at jgreiff@bloomberg.net