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