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Manager Risk? No thanks.

The state of Oregon is suing Oppenheimer Funds for understating the risk it took while managing a bond fund in the state’s college savings plan. From the Wall Street Journal:

Oregon charges that Oppenheimer Core Bond fund, which was in the state’s 529-plan options billed as “conservative,” became significantly more risky starting in late 2007 or early 2008. The fund lost 36% of its value in 2008, but its benchmark index, the Barclays Capital Aggregate Bond Index, rose 5.2%.

“The Core Bond Fund was no longer a plain bond fund,” the complaint says. “It had become a hedge-fund like investment fund that took extreme risks.”

When you invest in an actively-managed fund, there is a chance that the manager will make some excellent decisions (or get lucky), and thereby substantially outperform the relevant index/benchmark.

On the other hand, there is also a chance that he’ll get horribly unlucky or make a series of bonehead mistakes, thereby causing the fund to severely underperform.

In other words, active management makes your returns less predictable. It adds an additional level of risk.

The way I see it, taking on additional risk only makes sense if you’re being compensated with an increase in expected return. Unfortunately, as we know, choosing active funds over passive funds does not increase your expected return.

[Quick note: I say “expected return” rather than simply “return” because the very nature of taking on risk means that returns are not possible to predict precisely. Example: Stocks have a greater expected return than bonds, but there’s no telling ahead of time whether stock returns will be greater or less than bond returns in any particular period.]

Many investors gain comfort from knowing that a professional is managing their money. Odd as it may sound, I gain comfort from knowing that nobody is managing mine.* 🙂

*Yeah, OK. I guess I’m managing it in the sense of choosing an asset allocation, selecting specific index funds, and so on. But you get the idea.

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Comments

  1. “The way I see it, taking on additional risk only makes sense if you’re being compensated with an increase in expected return. Unfortunately, as we know, choosing active funds over passive funds does not increase your expected return.”
    Ain’t that the truth!

  2. Sometimes investors come back and say “I didn’t know I was taking this risk.” That doesn’t automatically mean the manager is at fault. I’m not trying to defend the industry but I am interested to know if the State of Oregon read the prospectus. If so, they would have known what the fund could do. If they didn’t, isn’t it really their own fault?

  3. Hi Neal.

    I’m not defending the State of Oregon here at all. My whole point (however poorly made) was that choosing an actively-managed fund involves a real possibility that the fund manager will make poor choices.

    To hope that a fund manager can outperform his relevant index without accepting the possibility that he could underperform is nonsense.

  4. “To hope that a fund manager can outperform his relevant index without accepting the possibility that he could underperform is nonsense.”

    It is exactly because people want to believe that nonsense that lots of mainstream funds have become ‘closet’ index trackers. The managers will keep their highly rewarded jobs if they are within a couple of percent of the index, whereas wild deviation is more likely to get them fired or at the least see the fund suffer.

    So you then have the laughable situation of losing a percent or two of performance for a manager to *pretend* to active manage the fund while actually largely following the index and maybe hoping one or two tiny bets pay-off (or at least keep them looking busy at work!)

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