At The Money: Andrew Slimmon on Closet Indexing (April 17, 2024)
Are your expensive active mutual funds and ETFs actually active? Or, as is too often the case, are they only pretending to be active? Do they charge a high active fee but then behave more like an index fund? If so, you are the victim of closet indexing. We discuss the best ways to avoid the funds that charge high fees but fail to provide the benefits of active management.
Full transcript below.
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About this week’s guest:
Andrew Slimmon is Managing Director at Morgan Stanley Investment Management, and leads the Applied Equity Advisors team; he serves as Senior Portfolio Manager for all long equity strategies.
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TRANSCRIPT: Andrew Slimmon on Closet Indexers
[Musical Intro: Out into the cool of the evening, strolls the pretender. He knows that all his hopes and dreams begins and ends there.]
Barry Ritholtz: 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& P 500 index 15 years in a row. I’m Barry Ritholtz 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 Slimmon. He is the managing director at at Morgan Stanley 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 8 billion in client assets. Slimmon’s concentrated U. S. 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?
Andrew Slimmon: I think that the dangers is just what Bill Miller said, which is it’s giving the mutual 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 portfolio managers or money managers, mutual fund managers don’t outperform over time. It’s because they aren’t, they don’t drive enough differential to the index to justify the fee.
So in my opinion, Hey, good. It’s good for the industry. It is forcing managers to either, uh, get out of the business, investors to move to indexing or what’s going to be left is managers that are truly active that can justify Uh, charging a fee above a, you know, kind of index fee.
Barry Ritholtz: How do we get to the point where so many active managers have become little more than high price closet indexers? How did this happen?
Andrew Slimmon: Well, it’s the business, Barry, 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 very active, it’s going to be quickly become apparent whether you’re good or not.
So if you last in the business as an active manager, you must be pretty good. You end up with performance differential on a month to month basis. Some months you might be up 1%, the market’s down 1%. Some months you might be down 1%, the market’s up 1%. Over time, higher active share works, but clients tend to get on the scale on a very short-term basis. So if you slowly bleed under performance, 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.
Barry Ritholtz: So you’re, you’re just essentially describing, career risk, that this is a issue of job preservation for a lot of active managers.
Andrew Slimmon: There is statistical proof, academic proof, Barry, that the more you, the more active you are in your fund — So you differ from the index funds — 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 decade of 2000 to 2009, the number one performing mutual fund. domestic fund was a company called the CGM Focus Fund. It generated an 18 percent annualized return. Phenomenal. The average investor in the fund during that time generated a negative 11 percent annualized return. [wow] Let me repeat that. The fund generated 18 percent annualized return. The average investor generated negative 11.
The reason which, you know, when you think about it, it seems obvious is, well, the manager, he was never up 18%. He was up a lot one year and then money would flow in. And then he was down 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 year. 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.
Barry Ritholtz: So you keep mentioning active share, define what active share is and, and how do we measure it?
Andrew Slimmon: If, if you think about, uh, you know, my global, global concentrated fund, The MSCI world is the benchmark; it has roughly 1600 stocks. Global concentrate has 20 stocks, so it doesn’t own 1580 stocks that are in the index.
It is therefore a very, very Active son. So active share measures how much you differ from the index. If I’m in, if my benchmark is the S&P 500 and I own 400 of the 500 (which we don’t) you’re not very active. So it is proven over time again that active 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 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 active share because those instruments that I put into my fund weren’t actually in the index.
And so what you really want to measure is something called tracking error. And I apologize, getting wonky, but, but you, you don’t want to have a manager that has high access share because he’s making big kind of bets that have nothing to do with what he’s benchmarked or she’s benchmarked against. So tracking error is a measure of how volatile 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.
What you really want to have in this business is higher active share but not a lot of tracking or I’m not making a big directional bet against my benchmark. I just don’t own a lot of the benchmark.
Barry Ritholtz: 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.
Andrew Slimmon: That’s exactly right. And one of the dangers that I have seen and observed and studied before I started concentrated funds is what happened. What has happened in the past is say you have a manager that has a more diversified 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 if those, if that best idea, whatever it is, works really well, they do well. But if that best idea doesn’t work. then the fund, 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, uh, you know, in our global concert, we own NVIDIA, which has done great. Everyone knows about it. It’s a big position, But another big position in our portfolio is CRE, which is a cement company equally as large. What does AI have to do with cement? Not much. A third largest position is Ameriprise, which is a asset management firm. So you have a tech company, you have a basic materials company, and you have 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, high active share means a limited 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 then it didn’t work, and all their stocks, you know, were correlated to that idea.
Barry Ritholtz: So we keep coming back to volatility and drawdowns. For the people who are engaging in closet indexing, how much of that strategy is to avoid the volatility, to avoid the drawdowns, and in exchange, they’re giving up some performance?
Andrew Slimmon: Absolutely. The point that I was trying to drive with that story of the fund in the nineties is by the very nature that that manager had such a difference between how the fund did 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 fund management company, but it’s perverse to what drives performance over time.
I like to say Warren Buffett doesn’t own 400 stocks or 300 stocks? So why do these funds drive have so many, so many stocks it’s because I think it’s, it’s easier to. Manage kind of the, uh, client expectation.
Barry Ritholtz: Let’s talk a little bit about transparency. Your global portfolio is 20 stocks. Your concentrated us is 30 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.
Andrew Slimmon: 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, but it’s my, you know, I started my career at Morgan Stanley’s advisor in the nineties and what I observed was that, you know, everyone wants to think they add low, as Liz Anne Sonders said last on your podcast last week – I loved it – add low, reduce high. Actually, what? Because of the desire for preservation of well, what really has happened is, you know, some geopolitical event happens around the world and the market goes down and people want to sell or reduce their exposure to the market. And what I observed over time was that investors who held individual stocks were less likely to sell at the wrong time than when people just held the market.
So, whenever someone called, I was like, Oh my God, you know, something bad’s happened 4,000 miles away. If I could move the conversation to, well, I know you want to sell the market, but your biggest position is. Apple. “Whoa, I love Apple. Let’s not sell that.”
Right? Getting the conversation to stocks kept people invested, and the most important thing to do is to ride out the down 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, 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.
Barry Ritholtz: So to wrap up investors who want some of their assets and active management should avoid those managers that ape 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 Ritholtz, and this is Bloomberg’s At The Money.
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