A long time ago, someone in your life inevitably made the observation that “the devil is in the details’. Whether pertaining to buying a car or planning on how to make the wedding look ‘effortless’, as in most adages of old there is more truth in them than we first recognize. The same thing holds for investments. In this letter we’ll try to briefly describe, and try not to bore you in the process, the little details that make the very special equity funds you are invested in work better than their peers.
First, there must be the recognition that seems obvious when stating “stocks (equities) due better than bonds (fixed income) on average”. Unfortunately, in our opinion, the financial services industry does not always subscribe to that theory. Thus the proliferation of ‘floating rate loans’ or ‘high yield bonds’, the merits of which are a little higher return on your fixed income….when times are good. That concept is very appealing until you grasp the reality that when no bank will lend to these companies, and you do, you must be taking on some risk that is not fully apparent. These riskier fixed income funds dropped by a calamitous 20-30%[i] or more in the last Great Recession; not exactly your harbor of safety when you wanted it. There is a reason that these same instruments were called ‘junk bonds’ in the past, though social decorum now has us speak of them in the more fashionable term ‘high yield’. To have adequately compensated risk, and thus the enviable return accompanying it, equities serve a more constructive role to achieve it.
Now, to the equities. In the past 20 years, there has been an inexorable rise in the acceptance (allure) of index (also called passive) funds over their actively managed counterpart. Index funds have the data on their side of outperforming their active counterpart, which is why in spite of large and well-funded ‘hey look what I got’ hype in marketing expenditures, the percent of total funds invested passively has more than doubled from 12% to 27% over just the past 2 years[ii]. We’ve mentioned their outperformance before[iii], but what we’ve not mentioned is why the investments you are in are passive…but not index in the classical use of the term. Why? The answer is because the construction of the funds in an index have to follow that index; i.e. if you got the S&P 500 index fund, you have to buy (and sell) exactly 500 companies that define it. That approach, though better than the active philosophy, has limitations. Your specially constructed passive approach is NOT an index as it adheres to some very smart (and profitable) rules that try to eke out small additional returns by each action. Some of them are;
- You will not own an IPO (Initial Public Offering) stock. The early hype and lack of liquidity in these stocks on average makes them less of a good bet then they are proclaimed to be.
- You will be hugely diversified. There will not be simple sampling purchases of company stocks to mimic an index, but deep investing to gather all that the market will give.
- Real Estate Funds (REIT’s) don’t behave like stocks….so they are not considered stocks and added to the normal ‘index’. We have a special category for real estate to benefit from the correlation coefficient differences between that asset class and stocks (i.e. they zig and zag differently).
- Companies in financial distress, bankruptcy, or are the target of a take-over bid are removed from the portfolio.
- In your portfolio, you will be disproportionately weighted toward certain segments of the market where returns are higher; small cap companies, value companies, and more recently high-cash generating growth companies. Following a straight index investment regimen, we could not do this, and frankly your portfolio would not have done as well.
- Finally, and as only one example, various special filtering occurs. For instance, small capitalization companies that have a very high P/E (i.e. the rocket ships) will eventually be sold out of the Core portfolio because, again on average, these high P/E guys (high Price to Earnings ratios) have negative alphas associated with them. Or, like your mama would say in another old adage; “What goes up, must come down.”
Take all those things together, add in some very specialized and powerful trading regimes to buy lower than most, and sell higher than most, and the little things start adding up to look very good for you. That is why we describe the investments here not as an index construction but as massively-passive actively-filtered tailored portfolios that puts you into 32-34 separate but tightly integrated institutional asset classes.
Whew. That’s 10 years of research distilled into one longer than average letter. Hopefully you are NOT bored with the above details, but understand a little bit deeper why your investments are not only more diversified than the averages (thus safer), but also did better than the averages, and are likely to continue to do so.
[i] “Historic Changes in the High Yield Market” (Journal of Applied Corporate Finance (A Morgan Stanley Publiciation)• Volume 21 Number 3, Summer 2009, Frank K. Reilly, University of Notre Dame, David J. Wright, University of Wisconsin-Parkside, and James A. Gentry, University of Illinois)
[ii] “A Bull Market in Passive Investing” (Adam Zoll, January 6, 2014, Yahoo.Finance.com)
[iii] Mark M. Carhart, “On Persistence in Mutual Fund Performance,” doctoral dissertation, University of Chicago, December 1994
