WEBVTT - At the Money: Avoid Closet Indexing 0:00:00.720 --> 0:00:03.520 Added to the cool of the evening. 0:00:04.200 --> 0:00:06.400 He stros the pretender. 0:00:10.480 --> 0:00:11.239 He knows it. 0:00:11.440 --> 0:00:18.320 All his homes and dreams begin and under. What if 0:00:18.320 --> 0:00:21.079 I were to tell you that many of the active 0:00:21.160 --> 0:00:27.000 mutual funds you own are really expensive passive vehicles. It's 0:00:27.040 --> 0:00:32.080 a problem called closet indexing, and it's when supposedly active 0:00:32.120 --> 0:00:36.400 funds own hundreds and hundreds of names, making them look 0:00:36.440 --> 0:00:41.440 and perform like big indexes minus the low fees. None 0:00:41.479 --> 0:00:45.559 other than legendary stock picker Bill Miller has said closet 0:00:45.760 --> 0:00:50.680 indexers are killing active investing. That's from the guy who 0:00:50.720 --> 0:00:53.880 beat the S and P five hundred index fifteen years 0:00:53.920 --> 0:00:57.320 in a row. I'm Barry Riddolts, and on today's edition 0:00:57.400 --> 0:01:00.480 of At the Money, we're going to discuss how you 0:01:00.560 --> 0:01:06.160 can avoid the scourge of overpriced closet indexers. To help 0:01:06.240 --> 0:01:08.160 us unpack all of this and what it means for 0:01:08.240 --> 0:01:11.600 your portfolio, let's bring in Andrew Slemmon. He is the 0:01:11.640 --> 0:01:16.240 managing director at Morgan Staley Investment Management, where he leads 0:01:16.280 --> 0:01:20.319 the Applied Equity Advisors team and serves as a senior 0:01:20.319 --> 0:01:25.600 portfolio manager for all long equity strategies. His team manages 0:01:25.720 --> 0:01:30.959 over eight billion dollars in client assets. Simmons concentrated US 0:01:30.959 --> 0:01:35.280 portfolios have done well against the indices, and his global 0:01:35.280 --> 0:01:40.119 portfolio has trounced its benchmarks. Let's start with the basics. 0:01:40.640 --> 0:01:43.520 What are the dangers of closet indexing. 0:01:44.040 --> 0:01:46.959 I think the dangers is just what Bill Millinch said, 0:01:46.959 --> 0:01:50.040 which is it's giving the mutu fund business a bad name. 0:01:50.400 --> 0:01:53.360 And the reason for that is that if you are 0:01:53.560 --> 0:01:58.360 charging active fees, so inherently you're charging a fee to 0:01:58.440 --> 0:02:04.120 manage a fund, but you really don't differentiate from the index, 0:02:04.840 --> 0:02:10.880 then you can't drive enough active performance to make up 0:02:10.960 --> 0:02:14.880 for the fees differential. And that's why I think so 0:02:15.080 --> 0:02:19.000 many you know, the results is pertforming managers and money managers. 0:02:19.280 --> 0:02:23.519 Utual fund managers don't outperform over time. Well, it's because 0:02:23.960 --> 0:02:27.680 they aren't. They don't drive enough differential to the index 0:02:27.760 --> 0:02:32.640 to justify the fees. So, in my opinion, hey good, 0:02:32.760 --> 0:02:36.960 it's good for the industry. It is forcing managers to 0:02:37.040 --> 0:02:42.839 either get out of business investors to move to indexing, 0:02:43.480 --> 0:02:46.480 or what's going to be left is managers that are 0:02:46.600 --> 0:02:51.720 truly active that can justify charging a fee above a 0:02:52.200 --> 0:02:53.399 kind of index fee. 0:02:53.760 --> 0:02:55.880 How do we get to the point where so many 0:02:55.919 --> 0:03:00.000 active managers have become little more than high priced closet. 0:03:00.600 --> 0:03:01.040 How did this. 0:03:01.040 --> 0:03:06.640 Happen, Well, it's the business berry, which is if you 0:03:06.800 --> 0:03:11.600 run a very, very active fund, which over time has 0:03:11.919 --> 0:03:16.840 proven to generate excess return because at the end of 0:03:16.880 --> 0:03:19.640 the day, if you're not if you're very active, it's 0:03:19.720 --> 0:03:21.079 going to be quickly become. 0:03:20.760 --> 0:03:22.800 A parent, whether you're good or not. 0:03:23.000 --> 0:03:26.200 So if you last in the business as an active manager, 0:03:26.240 --> 0:03:31.840 you must be pretty good that you end up with 0:03:32.760 --> 0:03:38.960 a performance diferential on a month to month basis. You 0:03:38.960 --> 0:03:42.040 you know, some months you might be up one percent, 0:03:42.120 --> 0:03:44.680 the market's down one percent. Some months you might be 0:03:44.800 --> 0:03:48.160 down one percent, the market's up one percent. Over time, 0:03:48.800 --> 0:03:54.000 higher active share works, but clients tend to get on 0:03:54.040 --> 0:03:57.960 the scale on a very short term basis. So if 0:03:58.000 --> 0:04:04.960 you slowly believe underperformance, you're less likely to have clients 0:04:05.120 --> 0:04:08.840 pull money at the wrong time. Versus a higher active 0:04:08.880 --> 0:04:12.680 share manager might go through a period of underperformance and 0:04:12.720 --> 0:04:16.800 become it becomes more apparent on an immediate basis that 0:04:16.800 --> 0:04:20.520 they're underperformed. So there's kind of a business incentive to 0:04:20.680 --> 0:04:23.960 stick close to the index to keep the money in 0:04:24.040 --> 0:04:24.480 the fund. 0:04:24.760 --> 0:04:30.040 So you're you're just essentially describing career risk that this 0:04:30.120 --> 0:04:33.120 is an issue of job preservation for a lot of 0:04:33.160 --> 0:04:34.080 active managers. 0:04:35.560 --> 0:04:41.479 There is statistical proof, academic proof, barry that the more 0:04:41.839 --> 0:04:44.560 you the more active you are in your fund, so 0:04:44.600 --> 0:04:49.560 you differ from the fund, the bigger the spread between 0:04:49.720 --> 0:04:55.480 how your fund does and how the average investor. 0:04:54.920 --> 0:04:56.560 In the fund does. And I'm going to give you 0:04:56.640 --> 0:04:57.960 a perfect example of what I mean. 0:04:58.800 --> 0:05:04.280 The up two thousand to two thousand and nine, the 0:05:04.440 --> 0:05:09.600 number one performing mutual fund domestic fund was a company 0:05:09.640 --> 0:05:14.160 called the CGM Focus Fund. It generated an eighteen percent 0:05:14.360 --> 0:05:22.159 annualized return phenomenal. The average investor in the fund during 0:05:22.200 --> 0:05:27.320 that time generated a negative eleven percent annualized return. Let 0:05:27.320 --> 0:05:31.559 me repeat that the fund generated eighteen percent annualized return, 0:05:31.640 --> 0:05:34.080 the average investor generated negative eleven. 0:05:34.520 --> 0:05:36.000 The reason, which you know. 0:05:35.960 --> 0:05:38.480 When you think about it, seems obvious, is well, the 0:05:38.520 --> 0:05:42.200 manager he was never up eighteen percent. He was up 0:05:42.240 --> 0:05:45.000 a lot one year and then money would flow in, 0:05:45.480 --> 0:05:47.560 and then he was down in the next year a 0:05:47.600 --> 0:05:52.080 lot and money would flow out. So investors weren't capturing 0:05:52.160 --> 0:05:54.760 the best time to invest with the manager, which was 0:05:54.839 --> 0:05:58.480 after a bad year, and they were only chasing after 0:05:58.760 --> 0:06:01.720 good years. So the point of this is is that 0:06:02.080 --> 0:06:05.040 the further you go out on the spectrum of active, 0:06:05.920 --> 0:06:07.080 the more your. 0:06:07.120 --> 0:06:10.360 Flows become volatile. 0:06:10.839 --> 0:06:14.200 And so again it's it's just there's plenty of academic 0:06:14.240 --> 0:06:20.240 proof that says closet indexing leads to less flow volatility. 0:06:20.680 --> 0:06:25.440 So you keep mentioning active share. Define what active share 0:06:25.680 --> 0:06:27.240 is and how do we measure it? 0:06:28.040 --> 0:06:32.040 If you think about, you know, my global concentrated we 0:06:32.440 --> 0:06:35.640 the MSCI World is a benchmark. It has roughly sixteen 0:06:35.720 --> 0:06:40.919 hundred stocks. Global concert has twenty stocks, so it doesn't 0:06:41.000 --> 0:06:46.040 own one thousand, five eighty stocks that are in the index. 0:06:46.200 --> 0:06:50.200 It is therefore a very very active sun. So active 0:06:50.279 --> 0:06:57.000 share measures how much you differ from the index. If 0:06:57.040 --> 0:06:59.680 I'm in If my benchmark is the S and P 0:06:59.760 --> 0:07:02.479 five one hundred and I own four hundred of the 0:07:02.520 --> 0:07:05.880 five on which we don't, you're not very active. 0:07:06.000 --> 0:07:09.200 So it is proven over time again. 0:07:09.000 --> 0:07:13.280 That act to share is a definitional term that higher 0:07:13.800 --> 0:07:21.280 active share managers outperform over time because again you're going 0:07:21.320 --> 0:07:24.400 to find out pretty quickly whether they're good or not 0:07:24.840 --> 0:07:28.320 because they don't kind of benchmark hug. So it's a 0:07:28.480 --> 0:07:34.200 very good measure of how a manager difference. The however, 0:07:34.320 --> 0:07:38.800 which is very important is let's say my index is 0:07:38.920 --> 0:07:42.720 MSCI World. What happens if I didn't own any of 0:07:42.760 --> 0:07:47.240 those stocks, but I went out and bought bonds, copper futures. 0:07:47.280 --> 0:07:50.120 I'm making it up well. I would also have very 0:07:50.160 --> 0:07:53.680 high act to share because those instruments that I put 0:07:53.680 --> 0:07:58.560 into my fund weren't actually in the index. And so 0:07:59.200 --> 0:08:02.560 what you really want a measure is something called tracking her. 0:08:02.560 --> 0:08:06.280 And I apologize getting wonky, but but you don't want 0:08:06.320 --> 0:08:08.560 to have a manager that has high actives share because 0:08:08.560 --> 0:08:12.640 he's making big kind of bets that have nothing to 0:08:12.680 --> 0:08:17.000 do with what he's benchmarker she's benchmarked against. So tracking 0:08:17.040 --> 0:08:21.680 her is a measure of how volt your portfolio is 0:08:22.240 --> 0:08:26.320 relative to the index. So again, if I own say 0:08:26.560 --> 0:08:30.400 copper and bond futures and currencies, I might go up 0:08:30.440 --> 0:08:32.960 and down, but the days I went up and down 0:08:33.200 --> 0:08:37.280 probably wouldn't be consistent with the days the market went 0:08:37.480 --> 0:08:41.160 up and down, and so I would have what's called 0:08:41.440 --> 0:08:42.840 high tracking air. 0:08:42.960 --> 0:08:44.720 So what you really want. 0:08:44.520 --> 0:08:47.240 To have in this business is higher actors share, but 0:08:47.559 --> 0:08:50.079 not a lot of tracking her. I'm not making a 0:08:50.120 --> 0:08:54.240 big directional bet against my benchmark. 0:08:54.640 --> 0:08:56.719 I just don't own a lot of the benchmark. 0:08:56.920 --> 0:09:00.280 So it sounds like if you look too much like 0:09:00.320 --> 0:09:03.240 the index, you'll never be able to outperform it, because 0:09:03.280 --> 0:09:07.480 you'll just get what the index gives you. High active 0:09:07.480 --> 0:09:12.160 share makes you different enough from the index to potentially outperform, 0:09:12.679 --> 0:09:16.079 and as long as you steer clear of tracking error, 0:09:16.160 --> 0:09:19.480 you're not going to be so different that it no 0:09:19.559 --> 0:09:23.080 longer relates to that particular index or benchmark. 0:09:23.559 --> 0:09:24.560 That's exactly right. 0:09:24.880 --> 0:09:27.959 And one of the dangers that I have seen and 0:09:28.040 --> 0:09:32.760 observed and studied before I started funds con funds is 0:09:32.760 --> 0:09:35.440 what happened what has happened in the past is say 0:09:35.520 --> 0:09:37.880 you have a manager that has a more diverse fied 0:09:37.880 --> 0:09:41.040 fund and he or she has done great, and then 0:09:41.120 --> 0:09:42.920 the firm comes and says, hey, you know what you've 0:09:42.960 --> 0:09:47.040 done so great, let's take your best ideas and put 0:09:47.080 --> 0:09:48.559 it into a concentrated fund. 0:09:49.200 --> 0:09:52.840 The problem is a lot of times those best ideas 0:09:53.240 --> 0:09:55.560 are highly correlated. 0:09:55.760 --> 0:09:59.000 And so is I those If that best idea, whatever 0:09:59.040 --> 0:10:03.840 it is, works really well, they do well. But if 0:10:03.840 --> 0:10:09.120 that if that best idea doesn't work, then. 0:10:09.160 --> 0:10:11.640 The fun you know, more or less implodes. 0:10:12.280 --> 0:10:16.000 So this is why I think it's really important if 0:10:16.000 --> 0:10:22.520 you run concentrated portfolios, focusing on what is the correlation 0:10:23.640 --> 0:10:28.440 of the stocks in the portfolio are supremely, supremely important. 0:10:28.640 --> 0:10:30.160 And I'll give you an example what I mean. 0:10:30.520 --> 0:10:33.600 We own, you know, in our global construt we own Nvidia, 0:10:33.679 --> 0:10:35.439 which is done great, everyone knows about it. 0:10:35.400 --> 0:10:36.280 It's a big position. 0:10:37.040 --> 0:10:40.840 But another big position in our portfolio is cr which 0:10:40.880 --> 0:10:43.480 is a cement company, equally as large. 0:10:43.840 --> 0:10:46.199 What does AI have to do with cement? Not much. 0:10:46.280 --> 0:10:50.680 A third largest position is Amerprise, which is an asset 0:10:50.720 --> 0:10:56.040 management firm. So you have a a tech company, you 0:10:56.200 --> 0:10:59.840 have a basic materials company, and you have a finance 0:11:00.280 --> 0:11:04.280 you know, a finance company. That are all very large positions, 0:11:04.280 --> 0:11:08.920 but they probably don't all move together given the diversity 0:11:08.920 --> 0:11:12.840 of those of those stocks. So I think it's high 0:11:12.880 --> 0:11:16.200 active sharing these alimited no number of positions, but making 0:11:16.280 --> 0:11:19.560 sure they don't all zig and zag together, because what 0:11:19.760 --> 0:11:24.280 I've seen is concentrated managers that blow up. It's because 0:11:25.120 --> 0:11:27.240 they had a great idea and it worked for a 0:11:27.240 --> 0:11:30.080 while and it didn't work, and all their stocks, you know, 0:11:30.120 --> 0:11:31.680 were correlated to that idea. 0:11:32.200 --> 0:11:37.960 So we keep coming back to volatility and draw downs. 0:11:38.640 --> 0:11:42.600 For the people who are engaging in closet indexing, how 0:11:42.720 --> 0:11:46.560 much of that strategy is to avoid the volatility, to 0:11:46.679 --> 0:11:52.040 avoid the draw downs, and in exchange they're giving up performance. 0:11:52.880 --> 0:11:53.520 Absolutely. 0:11:55.480 --> 0:11:57.360 The point that I was trying to drive with that 0:11:57.520 --> 0:12:01.199 story of the fun in the nineties is by the 0:12:01.360 --> 0:12:06.320 very nature that that manager had such a difference between 0:12:06.360 --> 0:12:11.200 how the funded and how the investor did, it implied 0:12:11.280 --> 0:12:16.960 that there were huge swings in flows. You did well, 0:12:17.160 --> 0:12:21.400 money came pouring in. He did badly, money went pouring out. 0:12:22.080 --> 0:12:24.440 That's the only way you have such a differential. So 0:12:25.000 --> 0:12:31.920 closet indexing, the flows actually are they're not as extreme, 0:12:33.440 --> 0:12:37.160 and so it's easier to manage a fund that has 0:12:37.360 --> 0:12:40.839 less extreme flows. It's better for the in many ways, 0:12:40.880 --> 0:12:43.959 it's better for the you know, the fund management company. 0:12:44.480 --> 0:12:50.199 But it's perverse to what drives performance over time. I 0:12:50.400 --> 0:12:53.120 like to say, Warren Buffett doesn't own four hundred stocks, 0:12:53.120 --> 0:12:56.040 so why are three hundred stocks a lot of these 0:12:56.080 --> 0:13:01.000 funds drive have so many, so many stuff. It's because 0:13:01.080 --> 0:13:05.600 I think it's easier to manage kind of the client expectation. 0:13:06.000 --> 0:13:09.880 So let's talk a little bit about transparency. Your global 0:13:09.920 --> 0:13:15.480 portfolio is twenty stocks, your concentrated US is thirty stocks. 0:13:15.960 --> 0:13:20.640 Pretty transparent. Your investors know exactly what you own. Seems 0:13:20.840 --> 0:13:24.800 like the closet indexers are not quite as transparent. People 0:13:25.040 --> 0:13:28.520 think they're getting an active fund, but what they're really 0:13:28.559 --> 0:13:31.680 getting is something that looks and acts just like the index. 0:13:32.160 --> 0:13:32.360 Yeah. 0:13:32.640 --> 0:13:36.079 So I've given you the kind of the academic reason 0:13:36.160 --> 0:13:40.640 why the benefits of concentrated portfolios, which is called active share. 0:13:40.760 --> 0:13:44.400 Higher active share managers outperform over time lower active share. 0:13:44.600 --> 0:13:47.880 But then there's a practical reason, Barry, which I know 0:13:48.040 --> 0:13:50.360 that you know, we've talked about in the past, and 0:13:50.400 --> 0:13:52.840 you'll get a chuckle out of this, but it's my 0:13:53.240 --> 0:13:55.400 you know, I started my current Mortgane Steeling as an 0:13:55.440 --> 0:14:00.480 advisor in the nineties and what I observed was is that, 0:14:00.679 --> 0:14:03.600 you know, everyone wants to think they've added low. As 0:14:03.800 --> 0:14:06.520 Les Ansano said last on your podcast, I loved it. 0:14:06.960 --> 0:14:08.840 You know, ad low reduced high. 0:14:09.280 --> 0:14:15.360 But actually what because of the desire for preservation of wealth, 0:14:15.880 --> 0:14:19.960 what really happens is, you know, some geopolitical event happens 0:14:20.000 --> 0:14:22.320 around the world and the market goes down, and then 0:14:22.320 --> 0:14:26.560 people want to sell or reduce their exposure to the market. 0:14:26.600 --> 0:14:32.400 And what I observed over time was that investors that 0:14:32.760 --> 0:14:37.600 held stocks were less likely to sell. 0:14:37.360 --> 0:14:40.560 At the wrong time than when. 0:14:40.400 --> 0:14:44.200 People just held the market. So, you know, whenever whenever 0:14:44.400 --> 0:14:46.640 someone called them, oh my god, you know something bad 0:14:46.640 --> 0:14:49.280 has happened four thousand miles away, if I could move 0:14:49.320 --> 0:14:51.920 the conversation to, well, I know you want to sell 0:14:51.960 --> 0:14:54.640 the market, but your biggest position is Apple. 0:14:54.840 --> 0:14:57.520 Well I love Apple. Let's not sell that, right. 0:14:58.440 --> 0:15:03.000 Getting the conversation stocks kept people invested, and the most 0:15:03.080 --> 0:15:06.560 important thing to do is to ride out the downturn. 0:15:06.720 --> 0:15:09.760 So again what I thought was, hey, if I could 0:15:09.800 --> 0:15:13.280 start these funds that had just a few stocks so 0:15:13.320 --> 0:15:16.600 people could actually see their positions on a page or 0:15:16.600 --> 0:15:17.960 a page and a half. 0:15:18.120 --> 0:15:20.360 You know, they're more likely to stick with it. 0:15:20.680 --> 0:15:24.000 So there was the kind of academic reason, and then 0:15:24.080 --> 0:15:27.880 there was the practical reason, which is people stick with 0:15:28.320 --> 0:15:31.240 stocks over time less so than the market. 0:15:31.800 --> 0:15:34.720 So to wrap up, investors who want some of their 0:15:34.760 --> 0:15:39.480 assets and active management should avoid those managers that ate 0:15:39.560 --> 0:15:43.800 the indexes but charge high fees. That gives you the 0:15:43.840 --> 0:15:49.440 worst of both worlds, passive investing but high cost. Instead, 0:15:50.040 --> 0:15:53.080 you should remember that a huge part of passive success 0:15:53.200 --> 0:15:56.920 or low fees, low turnovers, and low taxes. If you're 0:15:57.040 --> 0:16:01.000 going to go active, well, then go active. Own a 0:16:01.080 --> 0:16:05.880 concentrated portfolio with some high active share so you have 0:16:05.920 --> 0:16:08.400 a chance to outperform the index. 0:16:09.440 --> 0:16:10.120 I'm Barry with. 0:16:10.200 --> 0:16:12.880 Haults and this is Bloomberg's at the mother. 0:16:21.200 --> 0:16:30.560 Are you there,