In The Headlines

The Rationale behind the Aggressive Shift to Passive Investing

The move from actively managed investments to passive index funds has been a hot topic lately. Fund flow data show that investors are voting with their feet. Some in the industry have dubbed this trend “flowmageddon.” Bill Miller, the legendary stock picker at Legg Mason Capital Management who beat the Standard & Poor’s 500 Index for 15 consecutive years, has an intriguing theory about why investors have been abandoning active investments which he shared in a recent interview. Although some people see passive investing as a form of active investing, he sees the precise opposite phenomenon: Active fund managers are often nothing more than high-priced “closet indexers.”

Most active investment management is too expensive – Miller suggests that about 70% of all active managers are really closet indexers because many of them pile into the same stocks as their benchmarks—just like an index fund. But a majority of them do not produce net results as good as the average passive fund because their fees are so much higher. So the choices are: You can buy cheap passive funds and match the market, or you can buy expensive active funds with the goal of beating the market. But buying expensive funds that are really closet indexers makes no sense. Miller points out that investors have begun to figure this out.

Many closet indexers are doomed to underperform – Miller points out the technical reasons so many closet indexers underperform. To minimize tracking error and to avoid large drawdowns relative to the market, most managers have limits on how much they can be overweight or underweight the various components of the benchmark (e.g., the sectors of the S&P 500). So-called active-share percentage is where the risk and reward comes from, Miller says. Managers whose funds differ a lot from the index in their concentrations have greater risk of drawdowns and underperformance. However, without that risk, there is no chance of outperformance. Miller adds “their active share—the amount by which they differ from their benchmark—is very low and thus their ability to outperform is also low, even before expenses.”

Volatility is the price you pay for performance – As an example, he notes that the active-share percentage—how much a fund deviates from its benchmark in composition—in the Legg Mason Opportunity Trust fund is close to 100%. “That means my tracking error is also high, and drawdowns can be high as well,” he said. But Miller is an exceptional stock picker. During the past five years, the fund has beaten the returns of 97% of its peers and outpaced the S&P 500 by an average of more than 4% points annually in the same period.

Job preservation is the reason for closet indexing – Hugging the benchmark is a form of job preservation. By guaranteeing a fund will not deviate too far from the market, the manager gets to keep his job, even with mediocre performance. Closet indexing is a tribute to John Maynard Keynes’ famous observation that “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
We are only halfway through the shift from active to passive – Miller estimates that when the dust settles, about 70% of equity assets will be in some form of passive investment. Given that passive beats active net of fees most of the time, this move makes complete sense.

The bottom line, as Miller sees it, is that the shift from active to passive has not been properly framed. He believes it is simply switching from expensive passive investing to inexpensive passive investing.

Citations

1. http://bloom.bg/2eNzUNx – Bloomberg
2. http://on.ft.com/2ePU8WA – Financial Times

The New York Times Looks to Secure its Digital Future

The New York Times recently announced its purchase of the five-year-old online product-recommendation consumer guide, The Wirecutter, founded by technology journalist and former Gizmodo and Wired editor, Brian Lam. The selling price was more than $30 million in an all-cash transaction. “The New York Times is the perfect home for The Wirecutter because of our shared love and commitment to reader service and public good through rigorous reporting,” said Lam in a press release. “And most important, we’re thrilled to have the chance to help Times readers find great gear that can improve their lives.”

Lam, who will stay on in an advisory role, founded The Wirecutter in 2011 and self-funded its growth. He created the site as a means to quickly and easily help consumers by providing pertinent buying advice and straightforward recommendations on quality items with lists that include the best in technology, gadgets, gear, home appliances and other consumer products. “We’re very excited about this acquisition on two fronts. It’s an impressively run business with a very attractive revenue model and its success is built on the foundation of great, rigorously reported service journalism,” said Mark Thompson, president and CEO of The New York Times Company, in a written statement.

Also part of the acquisition is The Wirecutter’s sister site, The Sweethome. Both sites have a strong editorial backbone of journalists making research-driven, powerful product recommendations. Both sites make their money via affiliate links, which generate revenue when consumers click on them and make purchases via e-commerce sites like Amazon, as well as niche and vertical-specific shops. The model is catching on with digital publishers as online advertising earnings continue a downward spiral. The Times saw a 7% decrease just last quarter with online ads.

Rather than building its affiliate linking business from scratch, The New York Times decided to buy one. The newspaper, which years ago charted a strategy of selling off its satellite publications, has made an exception to purchase one. The Wirecutter was likely appealing to newspaper for a few reasons. First, it makes the bulk of its money from affiliate linking fees, the price companies pay publications for referral traffic generated by links to their products. This revenue model has been adopted by several online publishers, including Gawker Media and Vox Media, which are seeking new revenue streams to support their journalism.

The deal also gives The New York Times a huge back-catalog of product reviews, making it a destination for the kind of service journalism it has been creating of late with new verticals: Cooking (for recipes), Watching (for TV and film) and Well (for fitness and health). As disclosed by Digiday in December, The Wirecutter has partnered with many news organizations in a bid for a larger audience. It has largely been successful, generating $150 million in ecommerce revenue in 2015 and punching above its weight in terms of clickthroughs.
The acquisition is also an investment in changing The New York Times’ culture. The Times, like other companies with newspaper roots, is looking to accelerate its digital transition, and buying a company with different subject matter expertise and a new business model is one way to accomplish that.

Similar thinking went into the Times purchase of About.com, a topical site with 500 verticals (which the Times later sold). It was a solid business but had a very different editorial standard than the Times itself. At the time, publisher Arthur Sulzberger said there were things the New York Times could learn as its owner about digital media for its core operations. As Thompson noted, “The New York Times is the definitive source for news, information and entertainment and now we’re working on becoming an authoritative destination for service journalism. The practical approach that The Wirecutter and The Sweethome take to product recommendations embodies the same standards and values that are the pillars of our own newsroom. Their service-focused guides align with our commitment to creating products that are an indispensable part of our readers lives.”

Citations

1. http://bit.ly/2f3wYLE – Forbes
2. http://bit.ly/2eDZZB5 – Poynter.com

The Good News Is . . .

• The U.S. economy grew at its fastest pace in two years in the third quarter as a surge in exports and a rebound in inventory investment offset a slowdown in consumer spending. Gross domestic product increased at a 2.9% annual rate after rising at a 1.4% pace in the second quarter, the Commerce Department said. That was the strongest growth rate since the third quarter of 2014 and beat economists’ expectations for a 2.5% expansion pace.

• Costco Wholesale Corp., a leading big box discount retailer, reported earnings of $1.77 per share, an increase of 2.3% over year-earlier earnings of $1.73 per share. The firm’s earnings topped the consensus estimate of analysts by $0.04. The company reported revenues of $36.6 billion, a 2.2% increase. Management attributed the results to strength in its Canadian and other international markets.

• TD Ameritrade announced on Monday that it would acquire Scottrade Financial Services, a rival discount brokerage, for $4 billion, in a bid for scale at a time when small investors are losing their taste for stock trading. The deal reflects the ongoing evolution of the investment business. In the current market uncertainty, small investors are more reticent to buy and sell stocks. Index funds and other so-called passive investments have also gained favor, limiting interest in owning individual stocks. The industry is feeling the pressure and the weak environment is driving a broad industry consolidation. The deal with Scottrade would give TD Ameritrade, which is based in Omaha, $944 billion in client assets and 10 million accounts. TD Ameritrade would also more than quadruple the size of its branch network.

Citations

1. http://reut.rs/2fdiUUY – Reuters
2. http://cnb.cx/1gct3xa – CNBC
3. http://bit.ly/2eXYMlR – Costco Wholesale Corp.
4. http://nyti.ms/2eXXVBX – NY Times Dealbook

Planning Tips

Guide to Helping Older Parents with Money

According to Pew Research, about one in seven middle-aged adults are members of the Sandwich Generation, providing financial support to both their parents and their children. The time may come when you do need to help your parents organize their finances if they ever become unable to do so, and it is always better to be proactive in this process rather than waiting until the family is in crisis mode. Below are some suggestions to help with this situation. It is a good idea to also consult with your financial advisor to determine the best strategies for helping older parents manage money.

Automate to make costs predictable – Set up auto bill pay for your parents’ accounts and write down instructions for them to log in. You can even call companies and ask them to change due dates so that all bills are due around a certain time for predictable cash flow.

Use services to simplify – Often, parents are still very independent but may need help in certain areas. There are many services that can fill the gaps—from grocery services like Blue Apron or Peapod to housekeepers. These services can help parents stay independent longer.

Make checklists – Weekly pillboxes with compartments make it easy to tell if the correct medication has been taken for each day. Use the same concept and make checklists for any other areas your parents need help remembering.

Be vigilant of scams targeting the elderly – Scammers and con artists can be charismatic and persuasive, and unfortunately they often target the elderly. Common tactics include impersonating a family member in need of financial help, asking for “confirmation” of financial information, saying that time is limited to take advantage of an investment opportunity, and even threatening legal action for vague reasons. Make sure your parents know that they should never give out financial information from an unsolicited call or email.

Ask your parents to write an instruction letter to be used in emergencies – Should your parents become incapacitated, the family needs to know how to make important decisions, but most people find these conversations uncomfortable. You can ask your parents to write a letter that will only be opened in an emergency, detailing health instructions, location of the will, and contact information for their attorney and other professionals. Even better, make a binder clearly identifying all of this information. Other options include buying ready-made kits, or storing documents in a secure virtual vault.

Citations

1. http://bit.ly/1ewvLcx – Nolo.com
2. http://bit.ly/1jwIXy7 – US News & World Report
3. http://bit.ly/2fhQ2e9 – Investopedia
4. http://bit.ly/2fhQNEi – Bankrate.com
5. http://bit.ly/2f0I0mr – MoneyManagement.org