Star fund manager in pot-and-porn dispute

The TCW Total Return Bond fund (TGLMX) is one of the best bond mutual funds around. Under star manager Jeffrey Gundlach, the fund is in the top 1% of performers in its Morningstar category over the last five years, and it's among the top 2% over the last 10. But Gundlach’s ouster last month, details of a power struggle, and lurid allegations in a complaint filed by TCW have investors wondering what the heck they should do with their money.

First, the prurient details: Fund firm TCW accuses former chief investment officer Gundlach of stealing data, clients and employees in preparation for founding his own firm, called DoubleLine. Gundlach told Bloomberg he had proposed a management-led buyout in September and didn’t get a response. TCW’s complaint says Gundlach, along with other then-TCW executives now working with him at DoubleLine, surreptitiously downloaded data covering 24,000 clients and other trade secrets. The complaint also alleges Gundlach tricked TCW into paying for a private jet to fly him and seven other TCW employees to visit art museums in Texas under the guise of “team building”; in actuality, says TCW, Gundlach was building his renegade team.

It gets worse. Gundlach, who personally earned $134 million over the last five years while making stellar returns in mortgage-backed securities, demonstrated “unfitness to remain a senior TCW officer and fund manager,” the lawsuit says. TCW describes him as “erratic, increasingly and openly confrontational.” They say employees – and Gundlach himself – referred to him as "the Godfather" and "the Pope." The day TCW fired Gundlach, the lawsuit says, the company found marijuana and pornographic magazines and videos in his office. You can read the gory details of TCW's allegations in this complaint.

Gundlach’s DoubleLine, in a statement, calls the allegations “meritless … a blatant attempt to damage DoubleLine’s business and clients.” DoubleLine and Gundlach will be fighting back with their own suit; “the false and hyperbolic personal attacks by TCW,” says DoubleLine, “are obviously a gratuitous and irrelevant gutter tactic, which merely underscores the weakness of TCW’s claims.” Gundlach told Morningstar Thursday night that the contraband found in his office didn’t belong to him.

This kind of drama isn’t typical mutual fund news. But for investors in TCW funds, the situation is more than an unusually juicy dispute. The funds Gundlach oversaw were some of the best performing bond funds of the last few years, and many investors have come to TCW specifically to take advantage of his expertise. So now, should investors stick with TCW’s new management team, move their money elsewhere, or follow Gundlach to DoubleLine?

A key consideration for investors facing a management change at a fund they own is to what extent the fund’s success is based on the smarts of a single manager versus the investment approach of the entire firm. This can be nearly impossible for an individual investor to figure out, but what’s happening with TCW is far different than that, say, what happened at value investing firm Tweedy Browne, where senior adviser Christopher Browne passed away last month at age 62. Browne had already transitioned away from day-to-day management. And he left behind a large team of experienced managers steeped in a clearly laid-out investment philosophy.

At TCW, not only did Gundlach leave, but he took with him more than 40 investment professionals. These included Luz Padilla, who managed TCW Emerging Markets Income (TGEIX), plus two members of her investment team. That fund is among the top 2% in its category over the past three years, according to Morningstar.

Gundlach himself has long been a highly respected bond manager, but rose to particular acclaim in the last few years by making shrewd calls on mortgage-backed securities. He loaded up on government-backed issues like those of Fannie Mae, and he stayed away from subprime and the like throughout 2007 and 2008. Then, when the credit crisis sent all those fancy mortgage bonds into the toilet in 2008, he backed up the truck. Investors poured into TCW Total Return Bond, which is entirely mortgage-backed securities and had a 7.11% annualized return over the last 5 years. Gundlach also managed TCW Core Fixed Income (TGCFX) which ranked in the top 10% of its category for five and 10 years. Could someone who's "erratic" and "unfit" to invest other people's money achieve these results and persuade more than 40 co-workers to follow him to a new firm? Seems unlikely.

Gundlach’s expertise, plus the drama, have already led many TCW investors to flee. Reports have as much as $3.5 billion leaving the firm. But Gundlach himself, in a conference call after his firing, told investors there was no reason to leave the funds -- that the portfolio was in good shape. (I hear he’s been singing a different tune since to larger investors, privately.)

It’s certainly true that TCW has replaced Gundlach and many of its team with experienced fixed income investors respected in their own right. TCW bought Metropolitan West Asset Management, which had its own $30 billion of assets under management (compared to $110 billion at TCW). While many have compared Metropolitan West Total Return Bond (MWTRX) with TCW Total Return and found it wanting, this is a bit unfair. The funds are different – MetWest’s is more diversified – and MetWest’s numbers are quite respectable, ranking among its category's top 10% of performers for three, five and 10 years. Says a TCW spokeswoman, “We believe we match skill for skill the capabilities of the previous fixed income portfolio management team.”

Morningstar analyst Eric Jacobson calls MetWest a “tremendously capable team” and says it doesn’t make sense for investors to knee-jerk yank their money out of TCW. That’s especially true if you hold the funds in a taxable account (and thus would have to pay taxes on any gains), and also true because, for now, you can't follow Gundlach; he doesn’t have funds available yet. “Taking your money out and putting it in cash, that’s not wise,” says Jacobson. Still, the lawsuit gives him some pause – will TCW and, for that matter, Gundlach, be distracted by the fight? The analyst thinks financial advisers may stay away from both firms just because the dispute feels messy.

Jacobson, I think, has it right. If you’re an individual investor who’s been using TCW funds to satisfy a particular fixed income slice of your portfolio, it's reasonable to sit tight. But given the soap opera this has become, you should watch the situation carefully and re-evaluate once DoubleLine introduces its offerings.

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