09.05.2014
By Terry Flanagan

Beware the Closet Indexer

In the parlance of investing, “active” and “passive” typically correlate with risk appetite. The lines between these buckets can blur, however, as many so-called active strategies closely track indices, while many passive strategies deviate significantly from the indices they’re meant to replicate.

Davidson Investment Advisors, a $1.2 billion company based in Great Falls, Montana invests long-term while seeking to maximize returns and limit risk.

Its investment credo comprises three core principles, according to Edward Crotty, chief investment officer and as co-portfolio manager for the Davidson Equity Income and Intermediate Fixed Income strategies.

“First, we take a long-term approach to investing,” he said. “We’re a fundamental bottom-up boutique asset manager, so we consider ourselves investors, not traders. We really understand the businesses in which we invest, and that is demonstrated in our relatively low turnover.”

The second principle is truly active portfolio management. “Active not in the sense that we’re going to be doing a lot of trading, but active in the sense that we are looking to position portfolios to outperform the market,” Crotty said. “To do better than the market, you need to be different than the market. What guides us in our investing is not so much what the benchmarks or indices are directing, but really the risk-reward tradeoff.”

Andrew Davidson, Davidson Investment Advisors

Andrew Davidson, Davidson Investment Advisors

Crotty, who worked at Goldman Sachs in New York as a research analyst and portfolio manager prior to joining Davidson, and his team of 12 portfolio managers seek quality companies with proven management, solid balance sheets and good growth potential. The team believes in these companies and hangs on to their investments for the long-term.

“A concept that we adhere to and buy into is the notion of high active share,” Crotty said, “Active share introduced in a Yale research study that looked at the universe of active managers. What they found was that a lot of the negative results have been due to a growing cohort of closet indexers in the asset management business. So we are truly active managers, and it’s exhibited by our high active shares in our strategies.”

The study to which Crotty refers, published in 2006 by Antti Petajisto and Martijn Cremers, finance professors at the Yale School of Management, revealed that nearly one-third of the U.S. mutual fund industry is comprised of “closet indexers” – funds that claim to be actively managed but passively invest most of their assets in the benchmark index – while truly active funds account for only about a quarter of the market.

The study introduced the concept of “Active Share,” defined as the fraction of a fund’s portfolio holdings that deviate from the benchmark index. The Active Share of a mutual fund ranges from zero (pure index fund) to 100% (no overlap with the benchmark), Active Share significantly predicts fund returns, showing that only the most active funds outperform their benchmark indexes while all other active funds underperform after expenses.

“There’s plenty of academic studies that have given a black eye to active management, giving rise to the popularity of passive management through indices, and the Yale study took a different approach.,” Crotty said. “They distinguish between what they would consider truly active managers, those that are willing to be different and the closet indexers, which are those managers that are charging fees for active management but are not doing much more than providing an expensive index.”

The third principle is delivering on risk, which means the allocation is driven by risk and return, not only looking for the upside but also looking at the type of risk being used to generate outcome.

“Being long term, we’re looking at investing in companies and putting portfolios together,” said Andrew Davidson, president at Davidson Investment Advisors. “Although most people call themselves investors, you need the ability to change strategies and really challenge yourself so you really understand why you own it.”

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