Goose Your Total Portfolio Alpha Using Addition By Means Of Subtraction

by: Jim Sloan


A couple of large index funds is the starting place for investors, but it is important to recognize their limitations and pitfalls both in playing defense and in seeking alpha.

What you don't own may be more important than what you do own, and may provide more alpha.

A comparison of two fairly similar Vanguard funds, one a mid-cap index, the other "selected" from that universe, shows the added value that may come from subtraction (of 88 holdings).

The same principle works with individual stocks, which add to emphasis in a portfolio but also dilute and decrease the weight of other holdings.

Investors might refer to the 2000-2003 smash-up when the best help for survival was in in not owning techs and dot-coms and other growth stocks the bubble dragged up.

Sometimes the best addition to alpha is in what you don't own. The present is a particularly good moment to consider this point. Most of us would like to own (or have owned) the FANG stocks if we could choose the moment in the past to have bought them. Right now, however, might appear to be not the best moment for piling into them. I'm not sure, however, just how many people understand that to buy a large cap portfolio right now, whether it's actively managed or an index, is often to accept large exposure to the FANGs and similar very high-priced new techs.

Ground zero for total portfolio construction is to own a couple of inexpensive index funds. It was what I suggested for my clients when I retired from the RIA business, and I was reminded of it recently when a good friend and tennis client who had just come into a meaningful lump sum asked for my advice. The easy, obvious solution is to buy a Total US Stock Market Fund, a Total International Stock Fund (in much smaller size), and a Total Bond Index Fund (in correct proportion based on age and risk tolerance).

It's pretty simple. Vanguard will provide all you need at a very low cost, and if you meet one of their modest hurdles for total assets they will even choose the allocation for you. They will also rebalance regularly. Nothing to it, right? You're all set.

Well, maybe not quite.

The best thing and the worst thing you can say about indexing is that it's the great second best. It will save you from making idiotic mistakes in serious size. On the other hand, it is something of a blunt instrument. You can probably improve on it with a little knowledge of the markets and some application of common sense. It also helps to know yourself and have reasonable goals.

What You Don't Want To Own

People have very different ideas of what they don't want to own. I had a girlfriend once (in the years between marriages) who wanted me to advise her but insisted on socially vetted investments to the extent that she wouldn't accept index funds. She was a very smart woman (3d in her class at Wellesley) but by her own admission a hardcore "bleeding heart."

I reasoned with her about this. Money is fungible, I told her, has no conscience or view of the world whatever, and if your money avoids something, someone else's money will replace it immediately to keep the value in accord with the prevailing market opinion. She didn't want to hear it. She didn't want me to confuse her with facts.

Not only did I fail to convince her, but a few years later I took a look at the socially conscious funds I had finally gotten for her. They had actually done pretty well. They had ducked a couple of scandals and some negative legislation, and they had also gotten her heavily into quite a few of the old tech funds where good governance and no-harm products provided the "social" fit. It didn't convert me to her view, but it did serve as one of the first moments where I considered the possibility that avoiding certain investment categories might actually help returns.

What I myself actually try to avoid is yesterday's winners, high PE stocks trading on a story or future hopes, or industries which I fear are teetering on a slippery slope. Current examples of the former might be consumer staples companies, telecoms, and utilities. They have been rocking for several years, largely because of the Fed suppression of rates causing poor returns on everything else. As a result, these companies - many of them fine businesses - are way, way too expensive compared to the rest of the market and their own histories, and vulnerable to a painful adjustment (or at least major underperformance for a long time) if the world ever rights itself. To buy them here is to predict continuation of dismal times to a very distant horizon. I call these companies the "semi-frothies."

The wildly overpriced frothies are, of course, the FANG stocks and a few of their cousins, including the biotechs. To own one of them is to assume that their business will compound wildly but steadily for a very long time before they settle in to merely outstanding growth at a reasonable growth-stock PE. Since I try to be a long term investor, I prefer to decline that bet. I just can't know enough. [Admission: I did a one month break-even round trip in Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL) from December to early January. It was the most reasonable of the FANGs. When the market started to crumble in earnest, the market god who looks after idiots whispered in my ear to get out.]

The trouble with the large cap indexes is the importance of the frothies and semi-frothies. You can check it yourself by checking position weights in the Vanguard 500 index fund, among others. If you buy a large cap index tomorrow morning, you are going to own a large and very disproportionate amount of these recent winners, even after the recent decline. The decline of Friday February 5, by the way, hinted that the market in aggregate may be beginning to notice. See this by Bespoke.

Stocks that seem to me at different stages of the slippery slope include the oil and gas industry and asset manager/brokerage industry. I dumped my two oil majors Exxon (NYSE:XOM) and Chevron (NYSE:CVX) on the first bounce after they began a real decline, and my oil service company National Oilwell Varco (NYSE:NOV) a little earlier. The trouble with the industry is that it has real short and intermediate term problems and some hard-to-calculate long term risks. I'll wait and see.

As for asset manager/brokers, don't get me started. Tobacco stocks provide a product which is better for you. I managed money professionally, so I really know, but take my view for what it is worth. It is probably a mistake to bet against the dunderheadedness of the general population, but I suspect that over a reasonable period, and perhaps with unexpected suddenness, the investor universe may wise up to the fact that these products and services are largely bogus.

And, oh, hell, I don't buy tobacco companies. Jean, I have to admit that you got me on that one.

How To Add By Subtracting: A Comparison Of Two Funds

There's more than one point of view about the great large cap and mega cap companies. Fayez Saroflim, the great Houston asset manager, always argued that the giant brand name companies had demonstrated that they knew how to do things and had gotten large on merit, so you should stick with them. It's a point of view. Buffett seems to agree with it, saying publicly that the money he has set aside for his wife, if she survives him, would be 90% in an S&P index fund, probably Vanguard, and 10% in cash for walking around money - some walking around money, eh!

My thinking is that Buffett mainly wanted to leave investment instructions that were unambiguous, good enough, and idiot proof rather than optimal. Nevertheless, a large index fund is the starting place, never mind the little distortions mentioned above. It's not quite good enough for me at this point, however.

Let me make a statistical case using two Vanguard mid-cap funds. I like mid-caps because they meet the Fayez Sarofim criterion to some degree - to become a mid-cap (2 to 10 billionish in market cap), you have to become successful and demonstrate some staying power. On the other hand, a 10 billion company is not likely a fad or a super frothy. The new tech companies IPO at large cap valuations, and even their private valuations before there is much in the way of sales or cash flow now almost always put them well up on the scale of the S&P 500. When you buy a mid-cap you are generally buying a real company priced as a real company.

So let's look at two mid-cap funds with a minor difference - the Vanguard Mid-Cap Value Index Fund (MUTF:VMVAX) and the Vanguard Mid-Cap Selected Value Fund (MUTF:VASVX). Here are a few stats out of the Vanguard site:

To start with, the Mid-Cap Value Index Fund contains 210 stocks. The Selected Value Fund contains 122 stocks. Think what this implies. The investment universe of Mid-Cap Value is the 210 stocks in the index funds. What the Selected Value Fund does, primarily, is to delete. It deletes 88 stocks in all. It is thus actively managed, and charges .44% for it versus the .09 for the passively managed Mid-Cap Value Index Admiral Shares. Now I don't much like paying for active management of any sort, but in this case it's a Vanguardian incremental cost of .35%, which doesn't bother me too much. Let's see what you get for it:

Let's be statistical. That's what you do when dealing with a collection of 100 or more stocks. To start with, Selected Mid-Cap Value did beat the index fund over all time frames, with the most significant difference at one year and ten years. But what do you own? The Selected fund averages slightly lower average PB (1.7 to 1.8) but also slightly lower average ROE (12.9 to 13.5). Where it excels, however, is PE (17.5 to 22) and much higher earnings growth (11.2 versus 7.1). Thus you get more growth at a cheaper price.

After looking at these statistics I like to do two more things. First I look at the percentage of each fund in various large categories of business. In this case Selected Value has about 7% less in consumer stocks, of which I consider staples overpriced and cyclicals in earnings trouble (it's hard to break down relative amount in cyclicals and staples because the two funds classify "consumer" elements differently). Selected also has less in telecom and utilities, less in technology, less in materials, and less in energy. I consider the former three areas overpriced (thanks to the Fed) and the latter two cheap but in real business trouble.

On the other hand, Selected is relatively overweight health care by a bit, overweight financials by quite a bit (6%), and overweight industrials by a ton (over 9%). I basically agree with these overweights. Mid-Cap health doesn't include frothy biotech and pharma, Mid-Cap financials exclude the big banks and insurance companies and are generally conservative plodders, and industrials are an area long into their recession with prices across the board reasonably well reflecting it. And industrials are pretty much here to stay.

Just to be sure, though, I give the holdings of each fund a quick up-and-down-the-list eyeball pass-over. I know that I won't be familiar with many of the companies. I just get an overall feeling, the way I do when I read through something like the Magic Formula list.

In sum I think that both funds are okay. The Value Index fund, after all, has already added by deletion (to my mind) the much more expensive (32 PE) growth part of the somewhat more expensive total Mid-Cap (26 PE) index.

If nothing else, the two-fund comparison makes clear a point about which many fund investors are deceived. Splitting indexes this way is strictly about valuation, not about growth or the lack thereof. The fund with the 15.7 PE has a 5% faster growth rate than the fund with the 22 PE. Think about that.

I don't own either fund at this point, but have them and several other Vanguard index and index-minus choices in mind. I would buy one of them in size from cash reserves if the market obliged with a significant decline and if that decline caused mid-caps to get cheaper relative to the total market (which seems to be happening at the moment).

It Works When Buying Individual Stocks, Too, Of Course

Now just consider this. When you own a portfolio of stocks, or even when you buy a single stock, it is an act of addition but it is often more important as an act of subtraction (or deletion, or dilution, if you will). My large position in Berkshire Hathaway (NYSE:BRK.B) (NYSE:BRK.A), which I use in part as mutual fund substitute, is a way of saying I want to bullet its sixty-odd various-sized businesses to the diminution of what I would own in indexes or most other funds. To my mind it dilutes away the corporate corruption, shareholder unfriendliness, overpaid managements, and lack of attention to capital allocation that you are very certain to buy into when own you any large fund.

Or consider this. While I have whittled down most equity stakes over the past year, I have really bought just three things. The first was a basket of quality REITs which I bought during the Fed scare last July because they appeared to have safe bang for the buck but also countered other stock investments - diluted my commitment to the non-REIT areas. I bought Precision Castparts (NYSE:PCP) in major size because convinced that the Buffett deal would go through (which it did ahead of schedule) and was happy to take 2% or so on my total cash reserves as against anything else I might do with it. And I bought United Technologies (NYSE:UTX) within the last ten days because I like industrials better than the rest of the market for a combo of safety, growth, and value, and liked UTX better than the rest of the industrials.


Buying individual stocks goes back lot longer than the existence of funds, the earliest of which appeared in the 1920s with index funds coming along thanks to John Bogle and Vanguard in the 1970s. For this reason it is well established in the mind of investors that buying a stock is a positive statement but less well established that it is also a negative statement (a subtraction of emphasis) when compared against all other stocks or other investment alternatives.

Or look at it this way. Going back to the decline that began in 2000, not owning the tech and dot-com frothies and their brand name semi-frothy fellow travelers proved to be the best way to survive. The decline of 2008-9 was a little different, but light exposure to financials would have helped. In the current markets, the best alpha, once we look back from a half dozen years or so in the future, may likely be seen to have been avoidance of the high-growth great-story absurdly expensive new techs and the relatively "safe" slow growth staple-like companies whose dividends have caused them to be bid up beyond reason. Share your thoughts.

Disclosure: I am/we are long BRK.B, UTX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.