There have been a few articles recently on Pimco's underperformance and the increasing concentration on the buy side of the bond market. There is danger, here, for large active managers and their clients.
Risk Assessment
Two years ago, I wrote a piece called Don’t Become the Market. I wrote it partly to explain JP Morgan's (NYSE:JPM 'London Whale'. Anytime you become big relative to a market that you use, your own actions affect the prices of the market. This means that a market dominated by a firm or set of firms pursuing a similar strategy will no longer be able to rely on prices as a reasonable guide in assessing risk.
Smaller players, who can trade without affecting prices, can still make their estimates of risk at current prices, and they can trade against larger players. Though there are initially economies of scale, once you get big enough as an active investment manager, the diseconomies of scale kick in.
Size Matters
It's relatively easy to outperform when you are a small manager. But when you get big as an active manager, you realize that you can’t find so many good investable ideas. Now, if you were a passive manager like Vanguard Bond (ARCA:BIV), you wouldn’t have to worry — just own an even slice of everything, and complain that you don’t get a decent allocation on bond IPOs.
Because of this, I tend to use smaller managers for money that is not passively managed. The smaller the manager, the more he can take advantage of off-the-beaten-track ideas. If he is a trader (unlike me), being small is an advantage if he has skill.
There is an exception to this, and it is for institutions that buy and hold fixed income obligations. In that case, holding 50% of the issue is not a problem if you’ve done your credit work right. You have no intention of selling, and you will bear the few losses that you take. If a large manager acts like that, it can work so long as its financing cannot run, and the defaults are not overwhelming.
My advice to readers is to use lesser-known and smaller investors when actively investing. If they have a a good record, use them.
You'll benefit with them as they grow.