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At the Money: Avoid Closet Indexing · Masters in Business

• 0:00
  Speaker 1: Added to the cool of the evening.
• 0:04
  Speaker 2: He stros the pretender.
• 0:10
  Speaker 3: He knows it.
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  Speaker 1: All his homes and dreams begin and under. What if
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  Speaker 1: I were to tell you that many of the active
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  Speaker 1: mutual funds you own are really expensive passive vehicles. It's
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  Speaker 1: a problem called closet indexing, and it's when supposedly active
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  Speaker 1: funds own hundreds and hundreds of names, making them look
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  Speaker 1: and perform like big indexes minus the low fees. None
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  Speaker 1: other than legendary stock picker Bill Miller has said closet
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  Speaker 1: indexers are killing active investing. That's from the guy who
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  Speaker 1: beat the S and P five hundred index fifteen years
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  Speaker 1: in a row. I'm Barry Riddolts, and on today's edition
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  Speaker 1: of At the Money, we're going to discuss how you
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  Speaker 1: can avoid the scourge of overpriced closet indexers. To help
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  Speaker 1: us unpack all of this and what it means for
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  Speaker 1: your portfolio, let's bring in Andrew Slemmon. He is the
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  Speaker 1: managing director at Morgan Staley Investment Management, where he leads
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  Speaker 1: the Applied Equity Advisors team and serves as a senior
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  Speaker 1: portfolio manager for all long equity strategies. His team manages
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  Speaker 1: over eight billion dollars in client assets. Simmons concentrated US
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  Speaker 1: portfolios have done well against the indices, and his global
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  Speaker 1: portfolio has trounced its benchmarks. Let's start with the basics.
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  Speaker 1: What are the dangers of closet indexing.
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  Speaker 3: I think the dangers is just what Bill Millinch said,
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  Speaker 3: which is it's giving the mutu fund business a bad name.
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  Speaker 3: And the reason for that is that if you are
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  Speaker 3: charging active fees, so inherently you're charging a fee to
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  Speaker 3: manage a fund, but you really don't differentiate from the index,
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  Speaker 3: then you can't drive enough active performance to make up
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  Speaker 3: for the fees differential. And that's why I think so
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  Speaker 3: many you know, the results is pertforming managers and money managers.
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  Speaker 3: Utual fund managers don't outperform over time. Well, it's because
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  Speaker 3: they aren't. They don't drive enough differential to the index
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  Speaker 3: to justify the fees. So, in my opinion, hey good,
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  Speaker 3: it's good for the industry. It is forcing managers to
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  Speaker 3: either get out of business investors to move to indexing,
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  Speaker 3: or what's going to be left is managers that are
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  Speaker 3: truly active that can justify charging a fee above a
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  Speaker 3: kind of index fee.
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  Speaker 1: How do we get to the point where so many
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  Speaker 1: active managers have become little more than high priced closet.
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  Speaker 2: How did this.
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  Speaker 3: Happen, Well, it's the business berry, which is if you
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  Speaker 3: run a very, very active fund, which over time has
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  Speaker 3: proven to generate excess return because at the end of
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  Speaker 3: the day, if you're not if you're very active, it's
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  Speaker 3: going to be quickly become.
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  Speaker 2: A parent, whether you're good or not.
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  Speaker 3: So if you last in the business as an active manager,
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  Speaker 3: you must be pretty good that you end up with
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  Speaker 3: a performance diferential on a month to month basis. You
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  Speaker 3: you know, some months you might be up one percent,
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  Speaker 3: the market's down one percent. Some months you might be
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  Speaker 3: down one percent, the market's up one percent. Over time,
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  Speaker 3: higher active share works, but clients tend to get on
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  Speaker 3: the scale on a very short term basis. So if
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  Speaker 3: you slowly believe underperformance, you're less likely to have clients
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  Speaker 3: pull money at the wrong time. Versus a higher active
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  Speaker 3: share manager might go through a period of underperformance and
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  Speaker 3: become it becomes more apparent on an immediate basis that
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  Speaker 3: they're underperformed. So there's kind of a business incentive to
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  Speaker 3: stick close to the index to keep the money in
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  Speaker 3: the fund.
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  Speaker 1: So you're you're just essentially describing career risk that this
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  Speaker 1: is an issue of job preservation for a lot of
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  Speaker 1: active managers.
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  Speaker 3: There is statistical proof, academic proof, barry that the more
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  Speaker 3: you the more active you are in your fund, so
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  Speaker 3: you differ from the fund, the bigger the spread between
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  Speaker 3: how your fund does and how the average investor.
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  Speaker 2: In the fund does. And I'm going to give you
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  Speaker 2: a perfect example of what I mean.
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  Speaker 3: The up two thousand to two thousand and nine, the
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  Speaker 3: number one performing mutual fund domestic fund was a company
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  Speaker 3: called the CGM Focus Fund. It generated an eighteen percent
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  Speaker 3: annualized return phenomenal. The average investor in the fund during
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  Speaker 3: that time generated a negative eleven percent annualized return. Let
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  Speaker 3: me repeat that the fund generated eighteen percent annualized return,
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  Speaker 3: the average investor generated negative eleven.
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  Speaker 2: The reason, which you know.
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  Speaker 3: When you think about it, seems obvious, is well, the
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  Speaker 3: manager he was never up eighteen percent. He was up
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  Speaker 3: a lot one year and then money would flow in,
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  Speaker 3: and then he was down in the next year a
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  Speaker 3: lot and money would flow out. So investors weren't capturing
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  Speaker 3: the best time to invest with the manager, which was
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  Speaker 3: after a bad year, and they were only chasing after
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  Speaker 3: good years. So the point of this is is that
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  Speaker 3: the further you go out on the spectrum of active,
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  Speaker 3: the more your.
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  Speaker 2: Flows become volatile.
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  Speaker 3: And so again it's it's just there's plenty of academic
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  Speaker 3: proof that says closet indexing leads to less flow volatility.
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  Speaker 1: So you keep mentioning active share. Define what active share
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  Speaker 1: is and how do we measure it?
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  Speaker 3: If you think about, you know, my global concentrated we
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  Speaker 3: the MSCI World is a benchmark. It has roughly sixteen
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  Speaker 3: hundred stocks. Global concert has twenty stocks, so it doesn't
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  Speaker 3: own one thousand, five eighty stocks that are in the index.
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  Speaker 3: It is therefore a very very active sun. So active
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  Speaker 3: share measures how much you differ from the index. If
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  Speaker 3: I'm in If my benchmark is the S and P
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  Speaker 3: five one hundred and I own four hundred of the
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  Speaker 3: five on which we don't, you're not very active.
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  Speaker 2: So it is proven over time again.
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  Speaker 3: That act to share is a definitional term that higher
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  Speaker 3: active share managers outperform over time because again you're going
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  Speaker 3: to find out pretty quickly whether they're good or not
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  Speaker 3: because they don't kind of benchmark hug. So it's a
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  Speaker 3: very good measure of how a manager difference. The however,
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  Speaker 3: which is very important is let's say my index is
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  Speaker 3: MSCI World. What happens if I didn't own any of
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  Speaker 3: those stocks, but I went out and bought bonds, copper futures.
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  Speaker 3: I'm making it up well. I would also have very
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  Speaker 3: high act to share because those instruments that I put
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  Speaker 3: into my fund weren't actually in the index. And so
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  Speaker 3: what you really want a measure is something called tracking her.
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  Speaker 3: And I apologize getting wonky, but but you don't want
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  Speaker 3: to have a manager that has high actives share because
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  Speaker 3: he's making big kind of bets that have nothing to
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  Speaker 3: do with what he's benchmarker she's benchmarked against. So tracking
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  Speaker 3: her is a measure of how volt your portfolio is
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  Speaker 3: relative to the index. So again, if I own say
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  Speaker 3: copper and bond futures and currencies, I might go up
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  Speaker 3: and down, but the days I went up and down
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  Speaker 3: probably wouldn't be consistent with the days the market went
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  Speaker 3: up and down, and so I would have what's called
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  Speaker 3: high tracking air.
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  Speaker 2: So what you really want.
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  Speaker 3: To have in this business is higher actors share, but
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  Speaker 3: not a lot of tracking her. I'm not making a
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  Speaker 3: big directional bet against my benchmark.
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  Speaker 2: I just don't own a lot of the benchmark.
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  Speaker 1: So it sounds like if you look too much like
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  Speaker 1: the index, you'll never be able to outperform it, because
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  Speaker 1: you'll just get what the index gives you. High active
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  Speaker 1: share makes you different enough from the index to potentially outperform,
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  Speaker 1: and as long as you steer clear of tracking error,
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  Speaker 1: you're not going to be so different that it no
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  Speaker 1: longer relates to that particular index or benchmark.
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  Speaker 2: That's exactly right.
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  Speaker 3: And one of the dangers that I have seen and
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  Speaker 3: observed and studied before I started funds con funds is
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  Speaker 3: what happened what has happened in the past is say
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  Speaker 3: you have a manager that has a more diverse fied
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  Speaker 3: fund and he or she has done great, and then
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  Speaker 3: the firm comes and says, hey, you know what you've
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  Speaker 3: done so great, let's take your best ideas and put
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  Speaker 3: it into a concentrated fund.
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  Speaker 2: The problem is a lot of times those best ideas
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  Speaker 2: are highly correlated.
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  Speaker 3: And so is I those If that best idea, whatever
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  Speaker 3: it is, works really well, they do well. But if
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  Speaker 3: that if that best idea doesn't work, then.
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  Speaker 2: The fun you know, more or less implodes.
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  Speaker 3: So this is why I think it's really important if
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  Speaker 3: you run concentrated portfolios, focusing on what is the correlation
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  Speaker 3: of the stocks in the portfolio are supremely, supremely important.
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  Speaker 2: And I'll give you an example what I mean.
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  Speaker 3: We own, you know, in our global construt we own Nvidia,
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  Speaker 3: which is done great, everyone knows about it.
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  Speaker 2: It's a big position.
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  Speaker 3: But another big position in our portfolio is cr which
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  Speaker 3: is a cement company, equally as large.
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  Speaker 2: What does AI have to do with cement? Not much.
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  Speaker 3: A third largest position is Amerprise, which is an asset
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  Speaker 3: management firm. So you have a a tech company, you
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  Speaker 3: have a basic materials company, and you have a finance
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  Speaker 3: you know, a finance company. That are all very large positions,
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  Speaker 3: but they probably don't all move together given the diversity
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  Speaker 3: of those of those stocks. So I think it's high
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  Speaker 3: active sharing these alimited no number of positions, but making
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  Speaker 3: sure they don't all zig and zag together, because what
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  Speaker 3: I've seen is concentrated managers that blow up. It's because
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  Speaker 3: they had a great idea and it worked for a
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  Speaker 3: while and it didn't work, and all their stocks, you know,
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  Speaker 3: were correlated to that idea.
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  Speaker 1: So we keep coming back to volatility and draw downs.
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  Speaker 1: For the people who are engaging in closet indexing, how
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  Speaker 1: much of that strategy is to avoid the volatility, to
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  Speaker 1: avoid the draw downs, and in exchange they're giving up performance.
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  Speaker 2: Absolutely.
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  Speaker 3: The point that I was trying to drive with that
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  Speaker 3: story of the fun in the nineties is by the
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  Speaker 3: very nature that that manager had such a difference between
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  Speaker 3: how the funded and how the investor did, it implied
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  Speaker 3: that there were huge swings in flows. You did well,
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  Speaker 3: money came pouring in. He did badly, money went pouring out.
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  Speaker 3: That's the only way you have such a differential. So
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  Speaker 3: closet indexing, the flows actually are they're not as extreme,
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  Speaker 3: and so it's easier to manage a fund that has
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  Speaker 3: less extreme flows. It's better for the in many ways,
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  Speaker 3: it's better for the you know, the fund management company.
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  Speaker 3: But it's perverse to what drives performance over time. I
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  Speaker 3: like to say, Warren Buffett doesn't own four hundred stocks,
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  Speaker 3: so why are three hundred stocks a lot of these
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  Speaker 3: funds drive have so many, so many stuff. It's because
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  Speaker 3: I think it's easier to manage kind of the client expectation.
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  Speaker 1: So let's talk a little bit about transparency. Your global
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  Speaker 1: portfolio is twenty stocks, your concentrated US is thirty stocks.
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  Speaker 1: Pretty transparent. Your investors know exactly what you own. Seems
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  Speaker 1: like the closet indexers are not quite as transparent. People
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  Speaker 1: think they're getting an active fund, but what they're really
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  Speaker 1: getting is something that looks and acts just like the index.
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  Speaker 2: Yeah.
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  Speaker 3: So I've given you the kind of the academic reason
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  Speaker 3: why the benefits of concentrated portfolios, which is called active share.
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  Speaker 3: Higher active share managers outperform over time lower active share.
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  Speaker 3: But then there's a practical reason, Barry, which I know
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  Speaker 3: that you know, we've talked about in the past, and
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  Speaker 3: you'll get a chuckle out of this, but it's my
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  Speaker 3: you know, I started my current Mortgane Steeling as an
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  Speaker 3: advisor in the nineties and what I observed was is that,
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  Speaker 3: you know, everyone wants to think they've added low. As
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  Speaker 3: Les Ansano said last on your podcast, I loved it.
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  Speaker 2: You know, ad low reduced high.
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  Speaker 3: But actually what because of the desire for preservation of wealth,
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  Speaker 3: what really happens is, you know, some geopolitical event happens
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  Speaker 3: around the world and the market goes down, and then
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  Speaker 3: people want to sell or reduce their exposure to the market.
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  Speaker 3: And what I observed over time was that investors that
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  Speaker 3: held stocks were less likely to sell.
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  Speaker 2: At the wrong time than when.
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  Speaker 3: People just held the market. So, you know, whenever whenever
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  Speaker 3: someone called them, oh my god, you know something bad
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  Speaker 3: has happened four thousand miles away, if I could move
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  Speaker 3: the conversation to, well, I know you want to sell
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  Speaker 3: the market, but your biggest position is Apple.
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  Speaker 2: Well I love Apple. Let's not sell that, right.
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  Speaker 3: Getting the conversation stocks kept people invested, and the most
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  Speaker 3: important thing to do is to ride out the downturn.
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  Speaker 3: So again what I thought was, hey, if I could
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  Speaker 3: start these funds that had just a few stocks so
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  Speaker 3: people could actually see their positions on a page or
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  Speaker 3: a page and a half.
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  Speaker 2: You know, they're more likely to stick with it.
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  Speaker 3: So there was the kind of academic reason, and then
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  Speaker 3: there was the practical reason, which is people stick with
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  Speaker 3: stocks over time less so than the market.
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  Speaker 1: So to wrap up, investors who want some of their
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  Speaker 1: assets and active management should avoid those managers that ate
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  Speaker 1: the indexes but charge high fees. That gives you the
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  Speaker 1: worst of both worlds, passive investing but high cost. Instead,
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  Speaker 1: you should remember that a huge part of passive success
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  Speaker 1: or low fees, low turnovers, and low taxes. If you're
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  Speaker 1: going to go active, well, then go active. Own a
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  Speaker 1: concentrated portfolio with some high active share so you have
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  Speaker 1: a chance to outperform the index.
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  Speaker 2: I'm Barry with.
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  Speaker 1: Haults and this is Bloomberg's at the mother.
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  Speaker 3: Are you there,