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