Of Closet Indexing And Stock Picking

Includes: SPY, XLF
by: Roger Nusbaum

Gary Kaminsky had an interesting "op-ed" that was very op, so to speak. He said when people go to a money manager, they (the money managers) are going to tell you to own about 100 stocks in the name of risk management, which he went on to say is a bunch of BS.

From there I think he was saying that at 100 stocks, you become a closet indexer and so have no chance of outperforming. He said that top money managers never own more than 30 stocks, he learned firsthand at Neuberger Berman, that he never wanted more than 30 stocks. He concluded with the "fact" that over the entire cycle, by owning a few names, that is how you make money. He said that this point was driven home countless times at a Goldman Sachs conference he attended earlier in the week.

A related question came in from Seeking Alpha founder David Jackson who asked for my opinion on the tradeoff of taking on the risk and effort to own stocks versus using broad based index funds.

It does not necessarily have to be that 100 stocks makes someone a closet indexer, that depends on the 100 stocks in question. A healthy dose of foreign stocks, small caps along with avoiding the largest 15 U.S. stocks and I would say that the portfolio is probably not a closet index. I would further say that a portfolio of the 30 (to use Kaminsky's number) largest SPX stocks would look identical to the SPX.

The chart compares the Rydex Mega Cap 50 ETF (NYSE:XLG) and the S&P 500 SPDR (NYSEARCA:SPY). That one is obviously 50 stocks, the 50 largest U.S. stocks, not 30 but I think makes the point that picking a number of holdings is not in and of itself enough to make the argument Kaminsky is making.

Generally speaking, for accounts large enough where individual stocks make sense (economically, risk tolerance-wise or subject to any specific client mandate), we target 30-35 holdings with the mix typically being 2/3 individual stocks and 1/3 narrow based ETFs. Where the individual stocks are concerned, we usually target 2-3% for each one with the idea being that with those numbers, a great stock pick will be able to move the needle on the portfolio but a lousy pick won't be ruinous.

Kaminsky's comments focus a lot on beating the market or not, and I think he is coming from the perspective of someone who manages the portfolio as opposed to a registered investment advisor, and this is not a distinction without a difference. Most people who hire help deal with an advisor who isn't necessarily a portfolio manager and the advisor's job is to keep the client on plan, prevent them from doing stupid things and give the client a decent shot of having enough money when they need it. This does not have to involve beating the market as opposed to staying reasonably close over long periods of time. This advisor may choose money managers in the context Kaminsky means and often for these managers it is all about performances.

Of course, some advisors will simply use index funds or provide a portfolio of some other kind as part of the overall service they provide. Our firm is in the middle in that we have portfolio management in house that employs a certain philosophy that hopefully clients understand and believe in.

To David Jackson's question, I have said many times that I believe for most people, the decision to use individual stocks boils down to time available to spend on the task and general interest in doing the task. In David's comment, asking the question he talked about the work involved with individual stocks and I agree that most people will not want to put in the time needed to monitor a portfolio of stocks, and the bigger point is that even if someone puts in the hours, there is no guarantee that they will add value with the work they do; David's context is individual investors managing their own portfolios.

The real risks to managing a portfolio of stocks (assuming a good amount of time is devoted) are behavioral factors. A reasonably well diversified portfolio (in terms of number of holdings and concentration of various things) is very unlikely to go down 50% in a down 25% world but repeated flawed behaviors will compound to do a portfolio in over time, and I can tell you that a lot of people do not learn from their mistakes or the mistakes of others.

People can make very bad decisions with broad index funds too.

My takeaway remains what it has always been, which is the extent to which it starts with the end user in terms of savings rate and making some effort to learn about markets and behaviors so as to avoid or at least minimize self destructive behavior. That is the majority of the battle for people who wish to undertake this on their own.