"Closet Indexing" Misconstrued

Friday's Wall Street Journal featured an article about two Yale professors who have developed a measure for determining how much "active" management is present in mutual funds. The term they use for those funds which do not exhibit sufficient active management is a "closet index."

I won't go into their methodology. From what I read, it sounds feasible. They essentially compare the weight of a security in a portfolio with its weight in an index like the S&P500. The greater the summed (and normalized?) differences in the weights, the more "actively" they judge the fund to be managed.

My issue with this is their characterization of a mutual fund, or any managed fund or account, as a "closet index" simply because it does not meet, according to their criteria, a test of how securities are weighted in the portfolio.

To me, as an equity portfolio manager, I have a performance measure to attain, at some acceptable or pre-determined risk level. How I do it is up to me, within the bounds of my stated investment policies and strategies.

Therefore, although this is not what I do, if I were able to outperform the S&P by selecting the right 3 stocks to weight differentially, at the right times, why should that matter to a client?

What a client pays for, or should pay for, ultimately, is performance. Not style. If he could do better than me, he'd be doing it. If the S&P could consistently outperform my strategy over the long term, I'd be doing something else.

Why should the simple weighting of a portfolio incur the connotation that it is not "actively" managed? Granted, the authors further investigated the relationship between their measure of active management, and fund returns. Those with higher active management scores, as defined by the authors, had higher returns. Sort of.

The WSJ article states,

"According to the study, active-share percentages are a good predictor of performance. Funds registering the highest active share beat their benchmark index by an average of 1.30 percentage points per year, while those in the lowest active-share group produced returns that, on average, fell short of their benchmark by 1.41 percentage points."

While directionally comforting, I don't know if this result is actually statistically significant. The article is silent on that point. However, I doubt many clients would be impressed by a performance spread of less than 3 percentage points per year around a benchmark as descriptive of good and bad portfolio strategies. We don't know what the average annual standard deviation is, but it's a good bet that it would be higher than this difference of mean performances relative to a benchmark.

Which is to say, isn't performance, at a variance or volatility level, really the measure of a fund or account? How much real-time information does anyone have about mutual fund portfolios? Not much, actually.

So while the Yale authors' approach may segment management styles into active and less-active, it isn't clear that the resulting performance differences are sufficiently great to do much with this. If they had found a statistically significant difference from the benchmarks, and that average difference was more in the 6+ average annual percentage point range, I think I'd be much more impressed.

Internet Usage & Cable System Upgrades

Today's Wall Street Journal featured a very interesting piece on a report by Cable Televsion Laboratories, the industry's research & development unit. In the report, the lab offered a scenario in which heavy future consumer usage of video on the internet could require substantial new upgrade investments by cable companies.

By contrast, Verizon's $20B fiber network was portrayed as capable of servicing this potential future demand.

After reading the entire article, I have to say that I would bet on something in the direction of the scenario requiring the upgrade investments. This is because so many major cable system executives went on record as being supremely confident that either consumer habits aren't going to change very much, or that they have sufficient current capacity to handle future online behavior.

Such overconfidence in technological businesses has an unfortunate habit of becoming, in retrospect, hubris. The music and film businesses have underappreciated the ability of the internet to change their business model. Broadcast networks have also been taken by surprise by the rapid growth of online video viewing. Booksellers have been affected by the likes of Amazon, even though the latter has not really made all that much profit with its own endeavor.

According to the WSJ piece, Cable Labs last affected the cable industry in the late 1990s with its reserach leading to digital on-demand services, leading to a $60B upgrade.

I don't personally care about this issue for purposes of investing in individual cable equities, or even, for that matter, Verizon. Rather, I just think that anytime an entire technology sector's senior ranks believe they have a firm grasp of consumer behavior, it's time to expect something different.

My recent posts concerning YouTube, Time Warner and broadcast networks suggests that technology in these areas can, simply by its existence, radically alter consumer behavior in unanticipated ways. In fact, the last linked post discusses Comcast's efforts to lock up substantial video licenses going forward. Thus, on one hand, they are investing in the future of online video content, but, on the other, they believe their capacity investments will handle the future as is.

I think a change in consumer habits will happen again with high-speed online usage of video content in the next few years. Anytime so many tech execs get comfortable believing in their ability to forecast consumer behaviors, it's a good bet that those behaviors are heading in another direction.

Inflation Concerns, Growth & Market Overreactions

I've watched with incredulity at investors' recent knee-jerk reactions to the Fed, oil supplies, and, yesterday, the PPI and core inflation numbers.

Each day is just a day, after all. A market full of mostly inept, mediocre investors behave as a herd, simply meandering without much coherent long term thinking.

Was it not just last week that, after a six week buildup, half of the pundits warned us that Bernanke & Co. have gone to sleep on their anti-inflation watch? Now, the inflation numbers do appear headed in the 'right' direction, after all.

Ooops!

But, wait. Growth is slowing. Yes, that's right- the business media has been harping on this for weeks. So, wasn't it surprising that recent retail sales numbers are actually pretty good? That wasn't supposed to happen, according to, once again, many pundits.

So.....growth actually does look good, with slowing inflation. Instead of the other way 'round. Maybe Larry Kudlow is right after all. This has been the 'greatest (economic expansion) story never told.'

Thus, we maintain our investment horizon as something more in keeping with the cycle of trends in performance, not investor reactions. Investor reactions are so easily, frequently and violently affected by misinterpreted news, that it seems futile to us to try to adjust to each new piece of daily news.

Instead, we focus on long-term performance and market trends. It has served us well in the past, and continues to aid us in being in the market for big moves, taking advantage of trends which support our positions.

AMD, Intel, Sirius & XM

In keeping with the slowness of corporate news on which to comment this month, I have several observations I will combine in today's post.

The Wall Street Journal ran an article today providing yet more evidence on how AMD continues to hustle to press its recently hard-won advantage over Intel. The latter is moving to market servers which will allow its 4-processor technology, an improvement over 'dual-core,' to be inserted into them upon the new processor technology's appearance in the coming months. Intel is lagging on this development.

Once again, AMD looks hungry, motivated and successful in a key market for their growth plans.

The Journal had a good article discussing the joint woes of Sirius and XM, the two satellite radio companies. This is looking like a business in which you may want to own the product, but you probably don't want to own the stock.

It turns out, similar to Detroit's unending financing giveaways, the two radio companies have engaged in massive teaser rates for buying and turning on their satellite units/services. Many of these plans end soon, and there is a lot of speculation that many of these subscribers won't stick. Analysts who follow the industry are now wondering if it will ever really grow out of a niche which encompasses people who follow the star talent which underpins the two radio services. They have both spent small fortunes on their on-air talent and various sports offerings, leaving them both bleeding rivers of red ink on the income statement.

Mel Karzanin is a brilliant guy, but he has to play the hand he's been dealt. It's beginning to look like this industry isn't going to be as ubiquitous as the two entrants were hoping.

As I discussed his XM service with a friend I visited over the weekend, I was very impressed with its capacity for mobile solutions. I'm not so sure, absent a need for a specific on-air personality, that I could not replicate some of the styles/stations in a fixed environment with just a PC, high-speed access, and speakers.

It continues to be an interesting product space to watch, but it's beginning to look more risky and less consistently successful in its performance, even if the latter is just about subscriber growth.

One more thought. Karzanin is a very shrewd guy. I caught him briefly on Cramer's show when I used to watch more than 30 seconds of it. Mel was pleading that it's about subscriber base growth now, and profits later, just like cable. Well, I have such respect for Karzanin that I'm frankly a little wary of him right now. His motives are suspect.

It's sort of like being on the 'other,' read 'wrong,' side of an equity deal from Goldman Sachs. Karzanin badly needs funding and time- and he's likely to say anything legal to get it. Now would not be the time I listened to his pitch for attracting equity capital.

If these companies become long-term, consistently superior total return plays, then there's plenty of time to wait and see either, or both develop into such. It looks like they have a ways to go yet before they arrive.

The Slim Pickings of August

It's August. The news is slow, for the most part. Even the Wall Street Journal is grasping for filler.

Witness the op-ed page today, featuring the former Salomon Brothers erstwhile "Dr. Doom," Henry Kaufman. Kaufman opines on "How the Fed Lost Its Groove."

Indeed!

Several things struck me about Kaufman's piece. Recall, if you will, that he was Salomon's lead guy on economics. Salomon was, primarily, a fixed income house. Thus, for Kaufman, economics is all about fixed income. And only fixed income.

Thus, the main thrust of Kaufman's editorial is the amount of debt being created due to the Fed's actions. Nowhere in his piece did I notice him mentioning their first responsibility- fighting inflation. Instead, he focuses on Wall Street trading business profit planning, risk taking, and private debt creation.

If memory serves, Kaufman left Salomon before it's rapid decline due to various scandals and poor strategic choices. He had difficulty creating and running a hedge fund. He spent most of the 1990's being wrong about the economy. Given sufficient time, he was finally "right" after making, gloomy forecasts for most of the decade.

Now, apparently, he's in the economic consulting business. Looks like he hasn't changed much at all, and how many of us do at his age?

Finally, more than anything, I sense in Kaufman's WSJ piece more of the "I should have Ben Bernanke's job" attitude. And I don't believe he was on George Bush's short list for the position, either. No, Henry Kaufman is just another has-been Wall Street economist who can't forgive the country, and Wall Street, for not giving him a better, more prominent position than the one he last held over a decade ago.

Why does anyone take him seriously, most of all the WSJ?