Hidden Risks Exposed in Gundlach's Departure from TCW Group

First the good news. You've chosen wisely, and your fund manager has done so well in the ten years you've been with him that he has been nominated as one of Morningstar's fund managers of the decade. The bad news? Your mutual fund firm has just fired him.

If that seems hard to believe, it would have been prior to last week, when TCW Group fired Jeffrey Gundlach, the award-winning manager of its Total Return Bond fund and replaced him with the management team from Metropolitan West, a firm that TCW acquired just a day earlier.

Gundlach managed roughly 70 percent of TCW's assets, and, as Morningstar reports, TCW's executives (and TCW's corporate owner Societe Generale) were apparently worried that, should he leave the firm, most of their clients' assets would as well, imperiling their profits. To forestall such an event, TCW purchased Met West, bringing in their well-regarded management team, and sent Gundlach packing.

Aside from being highly unusual, this whole series of events draws attention to a number of different pitfalls that investors in actively managed mutual funds face.

Most obviously, it highlights how divergent the interests of mutual fund investors are from fund managers. Clearly, given his record, Total Return Bond fund's investors would have been best served by keeping Gundlach at the helm. That fact, however, conflicted with TCW's and Societe Generale's interest in their profitability, which would have taken a tremendous hit had Gundlach decided to bail on them. It's hard to imagine how TCW can plausibly tell their fund investors that they are better off today than they were two weeks ago, and no matter what they try to tell them, the fact that the $12 billion Total Return Bond fund has suffered from nearly $2 billion in redemptions since the move was announced suggests that a significant number of investors aren't buying it.

Those shareholders who have yet to leave now face a quandary. They can stay put and hope that lightning will strike twice, and their new management team will pick up where Gundlach left off; or they can pull their money out of the funds (presumably incurring taxes in doing so) and begin their search anew.

While it's hard to recall a situation quite like this one, it does highlight another pitfall that active management presents: fund manager turnover. According to Morningstar data, the average manager tenure at stock funds that have been in existence for at least five years is just under six years. Thus, an investor with a portfolio of three stock funds held for 30 years can expect to have 15 different managers running their money during that time. And if the odds of finding one winning manager are long -- and they are -- the odds of finding 15 in a row are, well, let's just say that you shouldn't count on it.

Finally, this episode highlights a third risk that is reflected in the experience of the owners of Met West's funds. From all appearances Met West is a moderately successful firm -- they run a few funds with solid long-term track records, and a few that are more mediocre. More importantly, Met West was privately owned, a fact that has helped keep their funds' expense ratios at a reasonable level (and which likely had something to do with the decent performance of their mutual funds).

But those investors now find that their assets are managed by a firm owned not by a small partnership, but by a giant financial firm. Perhaps Soceite Generale will keep the expense ratios of their acquired funds at a reasonable level. But the fact of the matter is that they're interested in growing their own profits, either to boost their corporate bottom line, or (as is rumored) to maximize the price they'll get if they sell TCW to another financial giant. And the easiest way to accomplish that is to raise the expense ratios on the former Met West funds.

Thus Met West fund investors must keep a close eye on their fund expense ratios, and be ready to move on themselves at the first sign that Soceite Generale is interested more in the firm's bottom line than that of their fund investors.

Index investors, of course, have little reason to fear any of the pitfalls described above. Because their funds aren't managed in the traditional sense, they care little about their fund managers coming and going. As long as their investment tracks its index benchmark within a few basis points, they're content. And because index funds are commodities in the purest sense, index fund investors are free to focus solely on the one point in which index funds might differ -- their expense ratios -- and stand ready to punish any index provider who raises fees by yanking their assets before the ink on the new prospectus is dry.

As this episode reinforces, there's no denying that a strategy that relies upon actively managed funds requires a much higher degree of vigilance than one that utilizes passive index funds. And given the amount of work and oversight that is required to navigate a field with so many hidden risks (to say nothing of the obvious ones), it's amazing that so many investors have yet to fully embrace a passive approach.