Brian Andrew, CFA

Futbol vs Football

The World Cup is well under way in Moscow. A total of 32 futbol teams (soccer for the uninitiated fan) have gathered together to vie for the Cup. Here in the U.S. it seems soccer has seen a surge in interest, yet still doesn't command the same attention that the 3.2 billion global fans share for their beloved sport. To the U.S. fan, 90 minute games that end with a nil-nil score or a 1-1 tie seem hard to follow. However, to those who deeply understand the chess match taking place on the pitch, it is better than the Superbowl.

This back and forth reminds me of the investment discussion surrounding active vs. index (passive) management. A lot of the information on either side of the debate is provided without a deep understanding of the differences between the two strategies for investing in a basket of securities, and more importantly, without much regard for how one can benefit from both within their portfolio.

We are fans of both index and actively managed strategies and use them in our portfolios. Let's examine the differences and describe how they might be used together.

Index Investing

An index is a rules based basket of securities representing a market or market segment. A simple example is the Russell 1000 Index. The index provider, Russell, uses a set of rules to build an index that represents the 1,000 largest publicly traded companies in the U.S. Those companies represent 92% of the total market capitalization of the U.S. stock market. The primary rule for constructing the index is that Russell will take the largest 1,000 U.S. based companies using their market capitalization (stock price times the number of shares outstanding for a company). Pretty straight forward. iShares, an exchange traded fund company, has a fund that seeks to replicate the performance of this index. The symbol is “IWB.” Vanguard also has a fund that seeks to replicate the performance of this index. Its symbol is “VONE.”

In 2017 the performance of these two funds was different by about 1/100th of a percent. They were up 21.52 and 21.53% respectively. The return of the Russell 1000 was higher than IWB by .15%. The difference between the funds' performance and the index is primarily a result of the funds' fees. IWB charges .15% and VONE .12% to manage their index portfolios. If interested in investing in the largest 92% of the U.S. stock market, these options would provide a simple way to do it.

Of course, there are many indexes that represent different markets. As the global exchange traded fund (ETF) market has grown from less than $200 billion 10 years ago to more than $2 trillion today, indexes have been created to invest in everything from high yield and investment grade bonds to stocks from most of the 32 countries being represented in the World Cup. Fees for these funds are not always as attractive as those mentioned above.

Knowing what market you want to represent, how the index is constructed, how well the fund tracks that index over time and how liquid the trading market is for the index fund are all issues we spend time understanding before we invest. Unlike IWB and VONE, there can be significant differences in how funds track an underlying index. Indexes also don't always have simple rules for inclusion.

Index Construction

This week, General Electric is being removed from the Dow Jones Industrial Average. It has been represented in the Dow since the index was created in 1885 and had only 12 stocks. The DJIA is an index, a basket which now contains 30 stocks meant to represent the U.S. stock market. However, unlike the Russell 1000 which is a simple rules based index, the team at Dow Jones has more mystery in its index selection process. Stocks are chosen by the editors of the Wall Street Journal, a publication of Dow Jones, using a broad set of guidelines rather than specific rules.

The word “industrial” in the index title is also a little misleading. There are only 5 industrial companies out of 30 — the rest represent other market segments such as technology (IBM and Microsoft), consumer discretionary (Apple and Nike), finance (American Express and Goldman Sachs) and health care (Merck and Pfizer) — to name a few. Given the lack of clarity surrounding how companies are selected to be in the index, one could argue that this isn't really an index, but rather an actively managed portfolio managed by the editors of the Wall Street Journal (who have a pretty good track record, GE notwithstanding).

A similar actively managed index is one of the most heavily invested in indices, the S&P 500 Index. This index has 500 U.S. listed companies, again meant to represent the U.S. economy. The methodology for inclusion in the index is not disclosed which implies that this is really an actively managed index rather than a pure index, like the Russell 1000.

Actively Managed

Investment strategies that are “actively managed” imply that a team of analysts and portfolio managers is looking at a particular market or market segment and using a variety of approaches to determine which stocks it wants to own in that market.

As an example, if a manager defines its strategy as active large cap, it may use a research approach of understanding companies' valuation, management capability and earnings projections to determine which of those 1,000 companies in the Russell 1000 it wants to own. Its portfolio might have anywhere from 10 to 200 stocks in it rather than the 1,000 included in the index.

There is a lot of misinformation regarding the efficacy of active approaches. It stems from the fact that most of what is written about them presumes you don't make any effort to find good active managers. Pundits will quote research saying that the average active manager underperforms its respective benchmarks.

Looking For the Ronaldos and Messis

That doesn't seem like news to me. It is a little bit like saying the average soccer player in the World Cup doesn't play better than Cristiano Ronaldo. (For those not familiar with the Portuguese player here is a link.)

Our job, no different than the team owners and managers for World Cup teams is to find the “Ronaldos” and “Messis” among the mass of talent. We use both a quantitative (think Moneyball) and qualitative approach to do so. As a result, we believe that the active managers we use provide value for their fees. We pay close attention to what drives their performance and how they do throughout a market cycle. This allows us to have the confidence to add to a manager when they've performed poorly and trim from a manager when they've bested their peers — similar to “buy low/sell high.”

Many also argue that active management is too expensive, quoting retail mutual fund expense ratios when making that statement. If I was writing for Money Magazine and making a reference for the average investor with $10,000 to invest that might be true.

But because we invest billions on behalf of our clients, our average expense ratio for actively managed funds can be as much as 50% lower than retail prices.

Taken together, the ability to seek the best managers through rigorous analysis and our larger pool of assets resulting in lower fees, provides benefits in finding active managers with whom we want to invest.

Active and Index Together – Best of Both Worlds

Combining both index (passive) and active management can provide the best of both worlds. In our view, this is done using both a desire for cost effective investment management and our perspective on where value exists in global markets.

If we are using index investments such as exchange traded funds, we are doing so to provide exposure to a market at a low cost. As an example, if we want to expose a portfolio to U.S. large cap stocks, and those stocks are inexpensively valued, an ETF such as IWB or VONE is the way to go. However, as stocks get more expensive, we can benefit from active management with a valuation bias that may eliminate the most expensive parts of that Russell 1000 index.

The discipline surrounding our investment manager selection, combined with the knowledge of how our active managers will do during different periods of a market cycle, and the research that leads us to cost effective index strategies provides us the opportunity to use both active and index strategies together.

Our drive to find the “Ronaldos” and “Messis,” our large pool of assets, and ability to discern when to use active or index management allow us to find the appropriate vehicle at a reasonable price and create the diversification necessary to achieve clients' objectives. Like those managing World Cup teams, it takes a lot of research and patience to arrive at the Cup with a contender who has the ability to win it all.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.