Fear and loathing in asset management, cont’d

Yesterday I addressed the topic of whether index investing is truly the road to serfdom. This is one of the sillier marketing ploys the financial services industry has trotted out lately, so it’s something I find worth harping on.

David Merkel from The Aleph Blog highlights another issue with this posturing:

There’s been a lot of words thrown around lately saying that indexing has been leading to overvaluation of the US stock market. I’m here to tell you that is wrong. I have two reasons for that:

1) Active managers have been pseudo-indexing for a long time. The moment they get benchmarked to an index they do one of two things:

a) accept it, gain funds for mandates that are like the index, and then they constrain their investing so that they are never too different from the index, and hopefully not in the fourth quartile of performance, so they don’t lose assets. This is the action of the majority.

b) Ignore it, get less fund flows, and don’t let the index affect your investment decisions. The assets should be stickier over time if you explain to clients what you are doing, and why. Only a minority do this.

This has been my opinion since my days of writing for RealMoney. All of the active managers out there add up to something close to a passive benchmark, less fees. It can’t be otherwise.

The one exception of any size would be stocks excluded from indexes because they don’t have enough free float available for non-insiders to own/trade. Even that is not very big — it might be 5% of the total stock market, though this is just a wild guess.

2) If you want to talk about valuation issues, you really want to talk about the trade-off between stocks and bonds, or stocks and cash. Stock valuations are never absolute — it is always a question of the other assets you are measuring the stocks against, and how you desirable those other assets will be in the future, and how sustainable the profitability of stocks will be over time.

There is a straightforward reason that pseudo-indexing (also known as “closet indexing”) is good for business. That reason is that most clients do not really want extraordinary returns.

That is to say, clients think they want extraordinary returns, but are not actually psychologically prepared to do what it takes to earn extraordinary returns. I use the word “earn” very deliberately here. Generating extraordinary returns is hard work, and it usually requires swimming upstream against consensus. Whenever you find a client who understands this (for they do exist) you should treasure that client.

Regardless of what they say, all clients really want is to achieve their financial goals. Inasmuch as portfolio returns are concerned, they are generally loss averse. That is, they dislike losses more than they value gains. This leads to an asymmetrical payoff for the investment manager. As an advisor or portfolio manager, you typically stand to lose much more by losing money when the market is up or flat than you stand to gain from outperforming the market when it is up.

So from a business perspective it is safer to put up middle of the road numbers than look too different from the indices or your competitors. The bottom quartile thing David mentions is a big deal. I have sat in the meetings where these issues are debated. Woe betide you if you find yourself in the bottom quartile of your peer group a couple of years in a row. Fire your sales team and wait for the numbers to turn.

Anyway, here is how you build a portfolio as a closet indexer. You pick something like 75 to 150 stocks, which keeps your largest positions to maybe 3% or 4% of the portfolio (if that). So even if one of those stocks goes to zero (unlikely) you are facing at maximum 3% to 4% of performance detraction from an individual name. This will be offset by some stuff you own that goes up, and it all kind of averages out in the end. Indeed, that is whole point. I cannot help but remark that this looks a hell of a lot like what the index investor is trying to achieve. (Mutual Fund Complex Marketing Person: “Ours goes to 11!”)

Likewise, you keep your sector weights within a couple percent of the benchmark weights, and the same with the individual stock holdings. You won’t own every security in the index. That’s okay. A lot of the securities in the index are crap — too much debt, negative cash flow and earnings, whatever. And anyway omitting some stuff will make you look better on certain measures that institutional research groups use, like active share.

If you are good you will maybe generate 1-3% of annualized outperformance over time, net of fees. If you are really good you might do even better. Unfortunately most closet indexers are not that good. There is plenty of data to support this (see below).

The two main statistics we use to measure the differentiation of an investment manager’s portfolio from a benchmark index (like the S&P 500) are active share and tracking error. Active share specifically looks at the overlap in holdings, while tracking error measures the volatility of the return differential over time (for quanty nerds this is the standard deviation of excess returns).

If you are a stock picker running a concentrated portfolio of your best ideas, you will score high on both measures. If you are a closest indexer, you will score low on both measures. There was a robust, if somewhat dated, exploration of this topic by Antti Petajisto in the Financial Analysts Journal in 2013. If you are interested in this subject you should definitely read the whole paper.

In the meantime, here are the relevant results from his cross-sectional analysis of US equity mutual funds:

Closet_Indexing_Stats.PNG
Source: Financial Analysts Journal, Vol. 69, No. 4
Closest_Indexing_Performance.PNG
Financial Analysts Journal, Vol. 69, No. 4
According to Petajisto’s data and criteria, about 64% of US equity mutual funds were either moderately active or closet indexers. However, the average assets under management for closet indexers was $2 billion, versus $1 billion for the entire data set.

So like I said, mediocrity sells. So much for efficient capital allocation.

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