Tuesday, December 10, 2013

Refuting an Attack on Indexation

Refuting an Attack on Indexation

Robert Olstein, portfolio manager of the Olstein All Cap Value Fund, received some valuable publicity in The New York Times on Sunday.[1]  Over the past 18-years Mr. Olstein has been managing his fund, and over that period he has beaten the S&P 500.  Mr. Olstein is a value-oriented investor.  The article focuses on Mr. Olstein’s distain for indexation.  He told Jeff Sommer of the Times that he finds arguments for index funds personally insulting.  He also thinks index investing is the acceptance of mediocrity.

I think Mr. Olstein’s perspective is perfectly understandable.  He’s an active money manager and couldn’t possibly go to work each morning if he didn’t believe he could beat the market.  Even though the majority of managers fail to beat the market, each one of them is convinced that they have the formula, be it in-depth research or computer models, to generate attractive returns.  Of course, most people queuing up for lottery tickets or walking into a casino also believe they are going to be winners.
Project Justice (1999)
Mr. Olstein has some evidence to back up his contention.  The return for his mutual fund, net of fees, has beaten the S&P 500.  It’s a record of sterling outperformance mixed with batches of gross underperformance.  Moreover, the biggest contributor to Olstein’s positive long-term record is two years of performance that occurred over a decade ago.  In 2000 and 2001, Mr. Olstein’s fund beat the S&P 500 by 54.3%.  During that two-year period the fund was up 34.4%, while the S&P 500 fell by 19.9%.[2]  I went back to fund’s annual reports to look at the fund’s holdings and Mr. Olstein’s commentaries.  Like most value-oriented investors, Mr. Olstein didn’t own Internet and telecommunications stocks in the 1990s and early 2000s.[3]  He also maintained a 10% to 25% position in fixed income securities and cash.   It is hard to say whether Mr. Olstein was lucky or smart in avoiding the tech bubble and hedging his bets with a fixed income buffer. 

There’s a deeper problem with ascribing much meaning to the fact that Mr. Olstein’s fund has beaten the S&P 500.  In reading the annual and semi-annual reports for the mutual fund in its early days, known at the time as the Financial Alert Fund, it’s evident that Mr. Olstein didn’t consider the S&P 500 to be the appropriate benchmark.  In fact, the benchmark cited in these reports as the appropriate comparison shifted over the years from the equal-weight Value Line 1000, to the Lipper Capital Appreciation Index, to the Lipper Midcap Value Index, and finally to the Russell 3000.  In addition to the changing use of cash and fixed income in the portfolio, I also noted huge changes in the amount of turnover or trading in the portfolio.  While variations in turnover are to be expected as valuations rise and fall, the fund tended to turn over by 100% to 200% in the early years and by 40% to 70% in the latter years.  In short, I’m not sure the comparison to the S&P 500 or the Russell 3000 (a broader index) is meaningful at all.  While Mr. Olstein’s research principles seem fairly consistent, his investment style, trading tactics, and risk management appear to have varied over the years.

There’s little question that Mr. Olstein is a smart investor and a savvy businessman.  Over the years he’s generated periods of highly marketable performance, and as the annual reports document, he’s been able to attract significant cash flows from investors.  During those periods he’s touted his investment record, just as he’s now promoting his record in The New York Times article.  Interestingly, in those periods when his record wasn’t as favorable, his investment letters tended to pay much less attention to the S&P 500 or even suggested that the comparison wasn’t appropriate. 

As I mentioned, Mr. Olstein is pretty savvy.  He’s been earning a 1% management fee while maintaining a relatively small staff over more than a decade and a half.  In the most recent Statement of Additional Information[4], the fund reported that Mr. Olstein owns 2% of the shares in the fund, which would translate into about $125 million.  I’m sure he’s worth a lot more than that.  It’s not hard to see why Mr. Olstein believes in active money management.

Is indexing a mediocre way to invest?  Even after granting that Mr. Olstein is one of the more talented portfolio managers in the world of mutual funds, indexation still remains a better alternative for most investors.  First, it would have been difficult to predict his success in 1995.  Remember, we are looking at all of this through a rearview mirror.  Second, it might have been a pretty wild ride depending on when you invested with Mr. Olstein.  While 2000-2001 was a stellar period for Mr. Olstein, the credit crisis didn’t treat his fund kindly.   Third, given the risks associated with his investment style, you’d probably have been best off only allocating a small amount of capital to Mr. Olstein.  Fourth, while Mr. Olstein has a co-manager, Eric Heyman, Mr. Olstein appears to own the vast majority of the firm according to the firm’s ADV filed with the SEC[5].  So if a bus hits Mr. Olstein you might well be looking for a new money management firm rather than focusing on long-term investing.

The odds of winning via active management are stacked against the average investor.  Moreover, the work involved in trying to unearth a genuinely gifted active manager is substantial.  In the end, most of us have better things to do than search through thousands of money managers to find a few who might be talented.  Even after 18 years, it’s still not clear to me that Mr. Olstein deserves to be in that elite company, notwithstanding his record.  Index funds get the job done for almost all investors whether they’re used to save for retirement or education.  There’s nothing mediocre about that.

[1] http://www.nytimes.com/2013/12/08/your-money/beating-the-market-as-a-reachable-goal.html?pagewanted=1
[2] http://www.olsteinfunds.com/allcap.html#calendar
[3] The funds’ annual and semi-annual reports are available at http://www.sec.gov/cgi-bin/browse-edgar?action=getcompany&CIK=0000944690&owner=exclude&count=40&hidefilings=0
[4] http://www.olsteinfunds.com/pdf/olstein_sai.pdf
[5] http://www.adviserinfo.sec.gov/iapd/content/viewform/adv/Sections/iapd_AdvAllPages.aspx?ORG_PK=38474&RGLTR_PK=50000&STATE_CD=&FLNG_PK=016C19C400080169039ED1A00445CCB9056C8CC0&Print=Y

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