Topics covered include:
- How index providers divide the stock universe into large and small, growth and value
- The difference between the price-to-earnings ratio and earnings yield and which is better
- How earnings volatility can impact annual earnings growth and what to use to estimate future earnings
- How value stocks often grow earnings faster than growth stocks
- How value has outperformed growth in the last three years
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Become a Better Investor With Our Investing Checklist
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today’s episode, 443. It’s titled, “Five Surprising Insights About Stock Indexes and Funds.”
Meeting With Managers
In 1995 I became an institutional investment advisor. As we structured portfolios, they typically had large-cap growth managers, large-cap value managers, we would have the same on the small-cap side, growth and value managers that invested in smaller companies. In order to determine which managers to recommend to our clients, we met with hundreds of managers per year, and we had a constant stream of investment managers on the stock side, the bond side, and eventually, other asset classes come to our office.
The first manager I ever met with was Anchor Capital Advisors, based out of Boston. They’ve just celebrated their 40th anniversary. When I met with a manager, I didn’t really have any idea what to ask them. They typically would have a presentation book; they would go through their charts. I remember asking a fairly detailed follow-up question about their strategy, that required some additional work on their part, and I never heard back, so we didn’t ever recommend them as a manager.
I loved meeting with managers. I was intrigued by both growth-style managers and values-style managers. And they were represented, both styles, in our investment portfolio. I would follow their stock picks, sometimes I would pair their stock picks; often it wouldn’t go very well.
A New Investment Product
After about six or seven, eight years of doing that, I decided, “Well, what if we managed money by taking the high-conviction stock picks of our top managers on a recommended list and put together a portfolio?”
Each manager’s top 10 holdings. This was more of a small to mid-cap style portfolio. And I backtested it. I got the ideas, and I spent several months going through a backtest to verify that the best ideas from our top managers would generate excess return, and then we could structure portfolios, model portfolios, or actual portfolios and manage assets in this way. It didn’t work. There wasn’t any excess return. And that was incredibly frustrating to me because potentially that meant we weren’t very good at our job in selecting managers.
After spending more time figuring out what was really driving it, I realized that in structuring this portfolio, I was using BARRA software to optimize it and to reduce the tracking error, which is the deviation that a portfolio has relative to a benchmark. And the way that you reduce tracking errors—you add additional holdings, or you reduce weights in particular holdings. And I had reduced the tracking error too much, to around—I believe it was 2% to 3% tracking error. And effectively, neutralized any bets in the portfolio; style bets, factor bets. Value. Yield.
And so I just had a portfolio that was made up of a number of holdings, about 100, that closely approximated the index, and underperformed the index net of fees. It was at that point I thought, “Well, what if I restructured the portfolio in a similar way, but using ETFs?”, which had only been around for a few years, and then we could allocate to those factors that were most attractive, be it value, growth, yield, or other elements. That backtest worked.
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