Monday, October 10th, 2011
degrees of difficulty

The current seriesthe research puzzle | This PDF link will show the series as it evolves. here on the research puzzle is intended to give those who make investment decisions (fiduciaries, gatekeepers, advisors, individuals) some different ways of thinking about the choices that they make.

This edition involves complexity and how it is assessed.  If sports like gymnastics and diving are judged on the basis of the difficulty of the maneuver that is being attempted, should we be doing the same with investing?  How would we do that?

Or let’s take climbing.  While the cliff line at Blue Mounds State ParkMinnesota DNR | The park is in extreme southwestern Minnesota. is only a hundred feet or so high, I can get to the top of it the easy way or the hard way.  How should you judge my performance?  How about if I climbed El Capitan with no ropes or crampons?

These thoughts come to mind in response to a piece in the Wall Street Journal by Ben Levisohn about Jeffrey Gundlach and DoubleLine.Wall Street Journal | The article appeared on October 5. (Today’s research puzzle pix also concerns Gundlach and his fund operation, so check that out for a chart and additional commentary.research puzzle pix | The topics covered in pix go from individual securities to asset classes and economics, and include looks at funds of all types (mutual, exchange-traded, closed-end, and hedge).)   Levisohn’s article says that Gundlach “has built an intermediate-bond fund that is far from typical.”

That he has and, as someone who applauds managers who take active risks rather than hugging benchmarks, I have no problem with that.  But the complexity of the DoubleLine funds is beyond the ken of most investors.  As the article says, Gundlach’s strategies make it “difficult for run-of-the-mill financial professionals, let alone retail investors, to understand what he is doing and how the portfolio will react under different scenarios.”  I’d take it even farther:  There’s a large swath of very sophisticated investors who don’t understand much of it either.

So, what is an investor to do? Of course, not to take performance at face value and extrapolate it forward.  I was quoted in Levisohn’s story on a couple of relevant points.  First, Gundlach has had the luxury of picking and choosing tranches of mortgage securities that may not be available as DoubleLine’s assets under management grow.  By chance, I had quoted Gundlach himself last year about how “size matters.”the research puzzle | For asset managers, size can make things easier or harder, as the posting’s simple graphic illustrates. The topic was also referenced on his August conference call, when he talked about the counterparty risk taken on by large bond funds that do swaps because they can’t find cash bonds in the size they need.

Second, the practice of buying on the basis of stated yields, so prevalent in the industry, is particularly questionable when a fund is growing rapidly or when it is using intricate mortgage strategies, both of which apply to DoubleLine.

This is a particularly interesting case study in so many ways.  There is a huge amount of key-person risk at DoubleLine.  Gundlach has proven to be a brilliant investor, but the proverbial bus doesn’t make exceptions on that basis.  Plus, if you’ve followed his career you might assert that there are risks that accrue by virtue of his personality.

Unfortunately, fund filings are infrequent or you could dig into the holdings to see how the exposures are changing.  So the best way to invest with DoubleLine would be via a separate account where you could see what was happening in something close to real time.  Even then, though, it’s a situation where very few would be trained to do the proper due diligence and it would take an incredible amount of effort.

Maybe, given all of that, DoubleLine should just go into the “too hard” pile.  Not necessarily, but its products should definitely be sized carefully in an allocation scheme.  You don’t want to put too many of your eggs in one basket if you can’t really understand what’s going on, even if you admire the manager.

Investing is not a sport where the degree of difficulty is factored into the scoring system.  Therefore, you need to take it into account yourself as best you can when making choices, even ones that seem attractive on the surface.