“401(k) platforms demand closet indexers,” Tom Howard bluntly, and emphatically, states. “They want name brands with high assets and attractive investments. It leads to what we call the Portfolio Drag Index, which consists of three components; asset bloat, index-tracking and over-diversification, all which combine to act as a drag on performance.”
Howard (or Dr. C. Thomas Howard, formerly of the University of Denver and current CEO of AthenaInvest) claims that if active managers simply bought their buy-side analyst’s 10 or 15 best ideas, kept assets capped at $1 billion and didn’t track to an index, they would all outperform.
Unfortunately, he adds, closet indexers account for 70 percent to 80 percent of the industry, with true active managers accounting for only 10 percent to 15 percent.
“We think if you are going to charge an active fee, you should truly be an active manager,” Howard laments.“The average mutual fund holds 130 investments. An active manager should have no more than 20, with 10 to 15 as ideal. In this way they can take full advantage of the reduction in volatility, and still gain superior performance.”
Howard doesn’t hold back about whom he feels is doing it wrong—namely Fidelity, T. Rowe Price and American Funds.
“American Funds are great stock pickers, but then they destroy all that value. We’ve been able to lift the PDI out, and find that it costs American Funds 600 basis points. Rather than a 10 percent return, they could be getting a 16 percent return. They are able to salvage only a very little bit of that and they keep it for themselves; they don’t return it to the shareholders.”
He further claims that those companies could still have the same amount of assets without the performance-destroying factors.
“It’s our view that the world would end up without closet indexers and only have true indexers and true active managers,” Howard adds, “but 401(k)s won’t allow it. We only have ourselves to blame.”
Style-boxes are another target of Howard’s ire, and he uses a football analogy to illustrate why.
“What if football players were grouped by height and weight, rather than by their job function?” he says from the 2016 Envestnet Advisor Summit in Chicago on Wednesday afternoon. “Imagine how frustrating that would be. The coaches wouldn’t know how to use them, but that’s essentially what happens with style boxes. I went and researched the concept, and it really developed out of nothing, but everyone ran with it. I call it the leaderless stampede.”
The question of the efficacy of style boxes weighed on Howard more heavily than most; so much so that it caused him to start his own firm specifically not dedicated to a style-box strategy. The result, AthenaInvest, is decidedly behavioral science in focus, which it uses to build wealth.
“We’ve found that adhering to style-boxes can cost a manger 300 basis points of performance,” he concludes.