MARK RIEPE: I'm a big basketball fan, and this past weekend I watched three games. Before each game, the network showing the games had a studio show where the upcoming game was analyzed.
After the studio show was done, the cameras shifted to the arena itself where the crew announcing the upcoming game analyzed it yet again. In this orgy of analysis, one phrase came up in the analysis of every single game, and that was, "Tonight's matchup will be a battle of contrasting styles."
That phrase is interesting to me because in these games you had two teams. Both are playing the same game. Both have the same goal of winning, and both are playing by the same set of rules.
And yet they go about solving the problem of how to win in different ways. Of course, not every basketball game features a contrast of two styles, but it does happen a lot. And this isn't just a basketball phenomenon. You see this sort of thing in every sport that I can think of.
It also isn't just a sports thing either. Companies competing in the same industry often have different business models. Political campaigns will employ different styles to attract votes. In geopolitics, nations will employ different strategies to achieve the goals of their governments.
It reminds me of a phrase attributed to the Greek poet Archilochus in 600 BC. He wrote, "The fox knows many little things, but the hedgehog knows one big thing."
A couple of points about that quote. First, I apologize to the descendants of Archilochus if I mispronounced his name. Second, it isn't obvious to me whether the fox or the hedgehog is more likely to be successful. My guess is that it depends on the situation and the specific problem to be solved.
My name is Mark Riepe. I head up the Schwab Center for Financial Research, and this is Financial Decoder. It's a podcast about financial decision-making and the cognitive and emotional biases that can cloud our judgment.
One financial decision is how to manage a portfolio. Most people, in effect, hire a manager to manage the bulk of the assets in their portfolios. That's essentially what you're doing when you buy shares in mutual funds or an exchange-traded fund or give discretion to an advisor when you open a separately managed account.
Before you hire someone to manage your money (or any job for that matter), it's prudent to spend some time understanding their approach before you commit to using them. In the world of money management, there are various approaches, but many fall into either the active management camp or the indexing camp.
On this episode I'm going to talk with managers from two firms. One firm is in my opinion a superior practitioner of active management, and the other is a manager from one of the fastest-growing index firms. After you listen to these two interviews, I hope you come away with two things. First, a better understanding of the decisions fund managers have to make so that you can be better informed when hiring managers for your own portfolios. And second, a few tips on how to manage the part of your portfolio where you make all your own decisions.
Joining me now is David Giroux. David is a portfolio manager at T. Rowe Price Investment Management. He also is the head of investment strategy and chief investment officer for T. Rowe Price Investment Management.
David, thanks for being on the show today.
DAVID GIROUX: Oh, it's my pleasure. Thanks for the invitation. Looking forward to it.
MARK: David, before we kind of get into the meat of the discussion, maybe could you just, you know, spend a minute telling me a little bit about how you got into this business? Were you one of those kids who was just always interested in the stock market, or is this something that you kind of evolved into over time?
DAVID: Actually, I really didn't get interested in the stock market until really my junior year of college. I really spent no time thinking about the stock market at all. I had, basically, my junior year, I decided I was going to be, or my sophomore year, I guess, I was going to be a business major, and I took some classes with some great professors, a guy named Jack Parham and another guy by the name of Howard Morris. And they really introduced me to the stock market, and they had such a passion for it that it really led me to read everything I could possibly read about investing, every book by Ben Graham or about Warren Buffett or David Dreman, and just really try to learn all I could about the stock market. And it just it was a … it was a passion from the start from the market. And really soon after that, I decided I really wanted to invest for the rest of my life. And so I luckily, I had the opportunity to come join T. Rowe Price in 1998 as an associate analyst, got promoted to an analyst 18 months later, and six years after that I was a portfolio manager, which is what I've been doing for the last 16 years now.
MARK: So now that you're kind of a professional investor, and you've seen the process of investing from a lot of different angles over the years, maybe give us a quick description of what your kind of day-to-day job is like.
DAVID: Well, it's interesting, the day-to-day job changes. It's nothing … no one day is the same, right? So like, for today, for example, right, I had two companies report their earnings for their fourth quarter. We listened to both those calls, you know, made some decisions around what should we do, was there anything unique to the thesis, our numbers. One name we added to today, you know, that was a little bit weak on their numbers for some short-term issues. We just got … I literally just got out of a management meeting with one of our largest holdings, who was in our office, spent an hour with him talking about their business, talking about capital allocation. So, you know, if you think about what I'm doing, I'm working in terms of trying to identify new ideas, both in the fixed income portfolio, as well in the equity portfolio, that have really good risk-adjusted returns. I'm trying to make a decision around, you know, should we be adding to risk assets? Should we taking risk assets off the … from a portfolio perspective? But, you know, no one day is the same.
MARK: You know, at the end of the day, you know, what you just described, you're gathering in, collecting all this information, and at the end of the day, you've got to make some decisions, what to buy, what to sell. So what's your … what's the process for turning that information into a decision?
DAVID: Oh, sure. I mean, what I would tell you is there's multiple different decisions that we have to be made. So, you know, one of the things we think a lot about is we kind of … for every company in the portfolio on an equity side, we will build out a five-year kind of internal rate-of-return expectation. That's really simply basically looking at the earnings power today, looking at that earnings power five years in the future, assigning what we believe is, hopefully, a conservative relative valuation to that company, relative to the market. So the market is at 18 or 17, this company will trade for 15 or 20. And kind of, you know, basically generating an internal rate of return, and monitoring that rate of return, and making sure we understand the risk-adjusted return, as well, of that company. And, you know, again, when those IRRs get really, really high for a company, you're usually adding to it. When those IRRs get a little bit lower for a company, you're usually probably cutting it back a little bit. So that IRR process is really important in terms of, you know, the process.
Now, from a fixed income versus equity allocation perspective, we are always kind of shifting that based on the environment. So we tend to be kind of very counter-cyclical in terms of how we invest. In periods of time where rates are low, you won't see us owning any Treasuries, and you'll see us having a lot of leveraged loans when rates are low. When rates are higher, you'll see us buying Treasuries. When the equity market is falling off a cliff like it did during … in February and March of 2020, we're taking cash down and we're adding equities.
MARK: One of the themes of the podcast is that at the end of the day, we're all prone to making certain decision-making errors; nobody is perfect. And one of the interesting aspects of working for a kind of a large company like T. Rowe Price is you've got the capabilities of putting in a lot of processes, guardrails, if you will, to kind of protect against any decision-making biases of any one individual. Could you describe some of those guardrails a little bit?
DAVID: Oh, sure. So at the T. Rowe Price level or the … you know, we would have guardrails around, you know, our … we have steering committees that review the holdings of every portfolio manager every quarter and ask questions of those portfolio managers. We have risk analyses that we see every day, in some cases. And then we have a risk review of the portfolio to make sure we're aware of our risks, again, every … we see the data every day, but we have a full review every quarter. As well as we look at the portfolio through an ESG lens once a quarter, as well. ESG is an important consideration today, and so we look at through an ESG lens.
But I would also tell you that, you know, portfolio managers have a lot of flexibility, right? So, you know, the way my portfolio might be positioned could be very, very different than the way another person's portfolio is positioned. Even though I'm CIO at TRPIM, or the T. Rowe Price Investment Management, I'm not dictating, you know, economic projections or interest rate projections and that every other portfolio manager needs to follow through on that. That's not how we work. We are a bottoms-up shop. We focus on trying to find really attractive risk-reward opportunities in equities and fixed income. And we're not a macro shop. So I'm not spending time saying, "OK, what's the GDP going to be? Therefore, let's go buy that stock." That's not how you create value in equities. And I don't think you have any … no one has any real strong edge on that.
So we want to have a lot of analytics that tell us, are we doing what we should be doing at this point in time? Is our portfolio positioned like we want it to be positioned—both from a long-term basis but also from a tactical perspective, as well?
MARK: So as you … when you're going through your kind of bottoms-up process of analyzing individual companies, presumably you get to a point where you've got a lot of different buy candidates, but you can't buy everything. Similarly, there will be times when maybe, you know, large parts of the portfolio maybe look less attractive than they did when you originally bought them, but you don't necessarily want to sell out of everything. So how do you translate your analytical process into then specific decisions on specific companies about which ones to buy and which ones to sell?
DAVID: OK, sure, great question. So what I would tell you is you think about the S&P 500®—you know, it's 500 companies in the market, obviously—but we're not going to touch probably about 400 of those companies. We're not going to touch companies where the valuation is just excessive. We're not going to touch companies that have poor capital allocation. We're not going to touch companies that can't grow earnings or combination of earnings and dividends at a high-single-digit rate over time. We're not going to buy empire builders. You know, we're not going to buy companies that have super cyclical business models. We're not going to buy companies that have secular risk. If you take out all those kind of bad companies, if you will, it leaves you with a universe of about 100 names. And for those 100 names, we do a lot of analytics around those names constantly. And what you would find over time if you look at our portfolio is, you know, even though we typically only own 40 to 50 stocks at a time, you know, some stocks will come in, some stocks will come out, but that 100 doesn't change that dramatically.
So we are constantly saying, "Where is there value in the marketplace? Where is the best risk-reward in the marketplace?" And we don't really care what the market is telling us what we should do. We're going to take a little bit longer time horizon and say, "Over a five-year view, we think these are going to be really good returns." And that just naturally … what you find is when things feel good, we own a lot of utilities and staples and lower-risk stocks, and when the market falls out of bed, and the market goes down 25%, we're adding cyclicals. And then we kind of repeat the process.
MARK: Another thing you've got to do, in addition to identifying the names, is deciding how much weight in the portfolio to put on each one of those names. So how do you go about making that decision?
DAVID: It's a great question. So it's not simply the return, right? It's a culmination of kind of like four or five factors. So you're looking at the return, expected return over the next five years, the risk-adjusted return, the range of outcomes, right? Some companies have a very narrow range of outcomes. Utility, you know, when we think about some of our utilities … I'm not going to mention them today, but some of our utilities, these are companies that will grow earnings at 7% per year, we have a high-twos dividend, will give you a 10% return over time, and it's a range of outcomes that's very, very narrow. A semiconductor company, you know, a high-growth company, you know, the range of outcomes is wider. So the larger the range of outcomes, probably you mitigate the size of the position size there. And then there's also a question of like the quality of the management team. You know, how good is the capital allocation? And, honestly, is this something you want to own for the next 20 years? So you probably give … you have a larger bet on something that will be highly likely to still be in the portfolio in, I don't know, 2043.
MARK: You do mention that you had started out your career as an analyst. And so, presumably, now that you're sitting in the portfolio manager's seat, you've got analysts who are pitching you different ideas, you're talking to other colleagues that … you know, who are managing other funds, and they've got a perspective on different companies. When you have kind of a disagreement with the people who are working closely on the fund, at the end of the day, how do you resolve that?
DAVID: We have a very large team that works directly with me. And, again, what you would find is, you know, we do have agreement, we do have disagreements. My team pushes me to be better. They have perspectives. But I think what's nice about our interactions, Mark, are that we all have the same playbook. We know the same market inefficiencies. We might have a … you know, we have a modest disagreement, but those disagreements are not … it's things on the margin, right, for the most part. If you have the same underlying philosophy, the same underlying process, you look at the world the same way as I do, which everybody on the team does, you know, that kind of results in those disagreements being relatively modest.
MARK: How do you go about evaluating the value that you're bringing to fund shareholders? Everybody compares themselves to different benchmarks, you know, there are requirements to do that. How do you define success for shareholders?
DAVID: Well, we have a very high bar. We have three objectives for our clients. We want to outperform the market on a risk-adjusted basis every year. Second, over a three-year period of time, we don't want to have anyone ever lose money with us. And then over a full market cycle, or over … again, over, hopefully, over my lifetime, running the strategy, we want to generate S&P 500 returns with less risk. So, you know, since I took over the strategy in June 30th of 2006, you know, we've done 102% of the market's return with, you know, two-thirds of the market's volatility. And, you know, no other balanced strategy has done that. So to be able to generate equity-like returns with a materially lower risk profile is the ultimate objective of the strategy.
MARK: You had mentioned over, you know, a complete market cycle. And as I was listening to you just kind of describe your process earlier, it sounds like the process remains the same irrespective of market conditions. Bull market, bear market, flat market, the process remains the same, but the decisions may be different. Is that a fair characterization?
DAVID: Our process is always evolving. We always want to get better. Every year we look at our process and say, "What is it that we can do better every year?" Not like, "Oh, that stock didn't go well" But "What is it that we can add to our toolkit? What is … is there another market inefficiency out there that we can start exploiting? Is there something that we've been doing wrong from a fundamental perspective that we can just get better at over time?" Right? We believe in this idea of continuous improvement. You know, we want to get better every year, and we want to get … and if we get better every year from a process standpoint, that will generate better returns over a long period of time. So, you know, we're very, very process-focused.
So thinking about where do you put your risk bets on, and how much risk are you really taking? And a really important part of the strategy is finding those securities, whether it be in asset classes that have the best returns in the market. That's really what we're focused on.
MARK: A couple times you mentioned market inefficiencies and exploiting market inefficiencies. It also sounded like, from your description, that many of those inefficiencies are themselves rooted in decision-making biases that the market overall suffers from. Is that a fair characterization? I don't want to put words in your mouth.
DAVID: Oh, absolutely. That exactly right. Your point is a great one. You know, I think when we think about why is it that when the market goes down that people reduce their risk profile? They sell cyclicals. Why do they do that? Again, as a former cyclicals analyst who covered autos, covered industrials, covered building-products companies, when those stocks go down for cyclical reasons, that's a great time to buy them. But why do people sell them, right? Because they're trying to maximize performance tomorrow, which is kind of a, you know, no man's … it's not a great … you can't win at that game, as opposed to thinking one year out, two years out, five years out, right? You know, historically, you know, buying industrials when people think there's a recession going to happen, or even during a recession, your returns are awesome for industrials, cyclicals, during that period of time, right? So we're going to do what the history tells us and not what maybe what our emotions tell us. So that's one efficiency.
The other, I think GARP[1] investing is one of the great market inefficiencies we talked about. And if you have a minute, I'll just spend a minute on GARP investing and how powerful GARP investing is. Because if you think about most managers are kind of graded versus the Russell 1000 Value Index or the Russell 1000 Growth Index. And the problem with that is, you know, a lot of GARP stocks kind of fall in the middle. So, if you're a value manager, you might look at a company that trades at, you know, 1.2 multiple to the market, you know, a 20% premium to the market. You might say, "Well, that's too expensive for me. I'm a value investor. That's, that's too rich." And then a growth investor might look at the same company, and he might say, he or she might say, "Boy, that company, they only grow 6% organically, and we want companies to grow 10% organically." So there's no natural buyer for those stocks. And then you say, "Well, the hedge funds." What … hedge funds … well, hedge funds want high volatility. They want to make a call on a quarter. And that's what they do. That's their process.
And I think maybe the last thing I would just say is, you know, there's a lot of academic research on this. So why don't people … you know, utilities are … again, these are probably high-single-digit, 10% kind of algorithm companies. The combination of EPS growth plus the dividend that at half the market's volatility. You know, a lot of people, portfolio managers, people in my job, are not compensated on risk-adjusted returns. Most people are compensated on absolute returns. So the amount of risks they take is not something they focus on. And since they look at … they look at a utility and say, "Hey, utilities are 4% of the index. We just will ignore those." So you get these great companies that have a risk profile that is exceptional.
MARK: David, you mentioned GARP a couple of times, growth at a reasonable price. Could you tell us a little bit about, you know, kind of the hypothesis behind that style of investing? Why does it … why does it make sense?
DAVID: Well, first of all, a couple things. One, again, it's only about … we only characterize about 14% of the market as being kind of GARP-y stocks. I would say historically speaking, if you take a long-term view, where are the highest returns in the market over time? It's not value. It's actually not growth. It's the kind of stuff in the middle. I mean, that's just the reality of the last 40 or 50 years of returns is that's where the highest returns are, and, two, it's also where the highest risk-adjusted returns are. So, you know, growth tends to be a little more risky. Values … you know, value, depending on the composition of the value index tends … can be a little more risky. Actually, GARP not only has the highest returns but the highest risk-adjusted returns. And, again, we talked a little bit about … previously about, you know, this is where the market inefficiency is, right? We talked about all the reasons why these stocks trade at too low of a valuation given their fundamentals. So anytime you can buy something for a structurally lower price than it should be trading in the market, that's great.
MARK: Yeah. I think at the heart of it is, you hear a lot … you talk to a lot of people, even sometimes professionals, and they talk about growth, growth, growth, and what they pay for that growth is kind of an afterthought, which always seemed a little strange to me.
DAVID: That's the … your point is, is a great point. That's the issue with growth stocks, is that, you know, you typically … the reason why growth stocks typically underperform over a long period of time is that the valuations are so excessive that as their growth slows, just law of large numbers, their multiple contracts, right? The beauty of GARP stocks is, if they do it right, if they deploy capital well, that you have a situation where over time the multiple can actually go up, and, potentially, if you deploy capital wisely, you know, your organic growth rate, your EPS growth can go up, right? So you have these … your growth rate is slowing over time, but you're hoping it's still high enough that the multiple contraction doesn't eat into your total return. But with GARP stocks you got the best of both worlds. So, if you do it right, if you do it well, you got the … you get the growth, plus you get multiple going in the right way, multiple goes higher.
MARK: David, we've been spending most of the time talking about individual stocks. For the bond investor out there, how do you think about individual bonds and how to evaluate those?
DAVID: What we're trying to do is we're trying to take as much risk as possible and get as high a yield as possible, but up to a limit. We don't want to have anything where we think it's not money good. And so we want to make sure as we think about our bond exposure, we want to own credits that we are highly confident in almost any scenario are still money good. So, if you look at … if you were to look at our portfolio in fixed income, what you would find is, you know, a lot of companies that have very, very high enterprise values. Some companies are levered four, five, six times, but sometimes you have enterprise values in these cases that are worth anywhere from 12 to 20 times. So you have a giant margin of safety. So essentially what you're doing in fixed income is you are giving up some liquidity because high-yield bonds and leveraged loans are not as liquid as Treasuries, clearly, or even investment grade bonds. But in return for giving up a little liquidity, you're picking up 300, 400 basis points higher yield without any real risk of loss. So if you go through … and if you look at our names, again, it's not only having that high enterprise value-to-debt level, but it's also buying companies that the EBITDA[2] is not that volatile. So what do we own? Things like dental companies, things like animal hospitals, insurance brokerage, you know, software, those kind of … you know, business services companies, companies that the EBITDA doesn't change that much.
MARK: You've worked as an analyst. You've worked as a portfolio manager. You've worked as a CIO, where, you know, to a certain extent you're overseeing other portfolio managers. How has your perspective on investing changed as you've worn those different hats throughout your career?
DAVID: Well, I would say, again, every firm is different. And so my role as CIO is not really overseeing other people's portfolios. That's not really what I do. That's not the value-add that I provide. I think the value-add of a CIO is, again, not doing "growth is going to work" or "value is going to work," or "this is what GDP is going to be" or "this is what interest rate is going to be." That's not a lot of value-add. What my job is, is to highlight market inefficiencies to the platform, to highlight things that the market is not focused on. So, again, during the middle of COVID, I kind of put out an analysis saying, "Look, these are the kind of returns you're going to get by buying cyclicals if this environment plays out like the great financial crisis." You know, the platform, again, a lot of … maybe a little bit younger analysts, even maybe some even younger portfolio managers who had never really been through an environment like that and that kind of … that kind of 35% kind of selloff, you know, you have all this negativity in the marketplace, I need to step up, say, "Hey, look at the great returns, even if this plays out like the great financial crisis. We should all be buying cyclicals right now." That's something I need to do. Or, you know, a couple years ago, you know, with tax reform, say, "Hey, you know, look, the market is not putting any kind of optionality on this. This group of companies, if we have tax reform, they're going to give … their earnings are going to go up 15%. Maybe we should overweight some of those companies." Or, you know, more recently, you know, there's some risk around China and Taiwan over a … unfortunately, over next 10-year basis, there's some risk. So we're doing deep dives into that to make sure people understand that risk and can model that and understand that risk. But it's about thinking about things that the market is not focused on, identifying market efficiencies, and sharing those more broadly.
MARK: David, last question for you because I think we're titling this episode, you know, "How to Think Like a Portfolio Manager." What's one or two things that you've learned throughout your career that a self-directed individual investor could apply to their own process of making portfolio management decisions?
DAVID: I'd say a couple things. One, don't make investment decisions based on what the current macroeconomic consensus is. You know, I think some people say, "OK, the economy is good. We're going to do this action because the economy is good." You're just chasing your tail when you do that, because the economy is always changing, right? So if you're … if the economy feels good, "Let's go by cyclicals." "Oh no, the economy is bad. Let's sell cyclicals." You're constantly kind of buying high and selling low. That's not … so don't focus on, on that macroeconomic consensus. I'd say that's one.
And, two, when markets go down, people feel that they want to reduce risk, right? What's happened in the immediate past they kind of extrapolate into the future. That's not the way to do it. Actually, historically speaking, when stock markets go down, when risk assets are cheap, that's when you want to be adding risk. And when things are expensive and feel good, that's when you actually want to take risk off. It's very counterintuitive, but that's just the history of how the markets tend to work. So, again, you hear all these horror stories sometimes when people are like, "Oh, the market went down 20%. I got scared, so I moved my stocks into cash." That's exactly the wrong thing to be doing. When the market goes up 20, 30%, you shouldn't be adding to risk assets; you should be taking money off risk assets. When things go down, you should be adding to risk assets. It's a little counterintuitive, but that's how you create value over time.
MARK: Yeah, makes a lot of sense. David Giroux, this has been great. Lots of helpful, practical information. Thanks for stopping by.
DAVID: My pleasure. I really enjoyed the conversation. Thank you.
MARK: Next, to get a different perspective, I'm going to speak with someone who manages a passive index fund. At the time of this recording, Chuck Craig was the senior portfolio manager for Schwab Asset Management. In that role he was responsible for the oversight and day-to-day management of international equity index Schwab Funds and Schwab ETFs.
Prior to Schwab, Chuck worked at Guggenheim Funds, First Trust Portfolios, and PMA Securities. He holds a master of science degree in financial markets and trading and is a CFA® charterholder.
MARK: Chuck, thanks for being here today.
CHUCK CRAIG: Good to be here, Mark.
MARK: Chuck, before we get into kind of the main body of the interview, I wanted to just ask you how you got into this business. Were you a kid who was just always super interested in investing right from the very first time you had some money from a part-time job, or is this something you kind of evolved into as you became an adult?
CHUCK : No, I really didn't know much about investing growing up as a kid. I, actually, went into the Air Force for eight years out of high school. And when I was in the Air Force, I became interested in my own personal investments, and that led me … that interest grew strong enough that I went back to college and got a degree in finance and moved into the investment business. Once I was in the business, it took me about 10 years before I finally found, I guess what I've determined to be my calling, which is passive portfolio management.
MARK: So passive portfolio management, very different from active management. What's in the job description of a passive portfolio manager?
CHUCK: Yeah, passive portfolio management is really a very detailed and process-oriented work. Our primary goal is to track the performance of an index as closely as possible, but we have a couple of other goals that we try to follow, as well. One of those is we're trying to minimize or eliminate the tax consequences to the investors. And then another one is controlling trading costs. But along the way we also have to worry about things like following regulatory rules. And then I'm an international portfolio manager, so we have some complicated things that we need to understand, which is how do different markets handle things and what is actually allowable for a U.S. investor to do in certain markets? And then we have to trade currency. As we buy securities, we need to buy foreign currency to fund those trades. And as we sell securities, we need to trade out of that currency and bring it back to U.S. dollars.
MARK: Chuck, before we get into some of the details, maybe if you could just give us kind of a high-level view of the portfolio management process that tries to accomplish those objectives you just laid out.
CHUCK: Yeah, the process really starts at the index. So we are really trying to track our indexes very, very tightly. And the indexes make quite a few changes throughout the year. And most those changes are around shares outstanding in a company. So companies … certain types of companies, in particular, are often issuing more stock. Some companies are buying back stock. We see spinoffs of new companies out of existing companies, and oftentimes companies are being acquired. So anytime one of those events happens in an index, we'll typically make a change. And if the index makes a change, our first inclination is that we want to make a change, but it's not quite that simple. We need to look at whether the trade is actually warranted, and if it is warranted, how do we trade it efficiently at a price that's equal to or better than our index? And we also want to make sure that we can do that in a very tax-efficient manner.
MARK: Chuck, are there situations where the index makes a change and you decide, "Well, we're not going to replicate that change right away, and we'll get to it over time because it's just too cost-inefficient to do it right away?"
CHUCK: There are some of those. Typically, our default is to try and make a change with an index. However, if an index change is sufficiently small, we may shy away from doing that and kind of let it catch up as we are investing cash or raising cash, or, ultimately, at our regular rebalances that occur with the indexes.
MARK: Chuck, sometimes indexes are adding securities. Sometimes they're dropping securities. When a company is dropped from an index, is the inclination on your part to just immediately sell it all, or is it a little bit more complicated than that?
CHUCK: Yeah, like I said earlier, I think our default is to try and match the index treatment of a security. However, the question sometimes isn't about whether to sell, but how to sell. Certainly, in a lot of cases, those sale decisions are made by … are made based on the ability to tender shares to the issuing company or a third party who is trying to buy it. So we'll determine whether that's the best option or whether actually trading in the open market is the best option.
The other thing is obviously around the tax efficiency. And particularly in ETFs, we have special mechanisms to sell securities in a more tax-efficient manner. So, depending on the cost basis of the security, we may choose to trade it in the open market, or we may choose to utilize the special mechanism of what we call custom in-kind baskets to prevent the fund from having a taxable gain.
MARK: Let's talk a little bit about the size of the position. So an index has a list of companies that are in the index, and each of those companies has a weight associated with them. When do you know when you're close enough? In what situations do you want to just be tracking … you want … if the index has 10% of a company, you're going to own 10% of that company, and when is it OK to be a little bit off?
CHUCK: Yeah, well, our internal guidelines are very tight. So we do try to stay very close to the index. However, we utilize some sophisticated tools to allow for small what we call mis-weights between our portfolio and the benchmark. So we utilize a sophisticated optimization engine, some internal software we have for helping us be tax-efficient, particularly in the ETFs, and we use some sophisticated risk models, as well, that measure the likelihood that we track very closely to the index.
We utilize those tools even more … I guess even more extensively during the rebalances, where there are a lot of changes happening. During the rebalances, which are typically quarterly, you see a lot of securities being added, a lot of securities being removed because they no longer qualify for the index, and that causes basically every security in the index to change weight. In those instances, we can be trading a few dozen to over a thousand securities in a portfolio. We, obviously, can't look at each of one of those securities, so we need to utilize those sophisticated tools, the optimization algorithms and the risk models, to help us determine what is an acceptable level of mis-weight from the index.
MARK: Yeah, and by acceptable … or excuse me, by acceptable level, you mean you're tracking it really closely, but the cost of getting even tighter tracking would just be too high, given the fact that after tax returns, after expense returns, are ultimately what matters to your shareholders.
CHUCK: Right. We're balancing managing active risk … that is, the risk that we don't track our portfolio … against those transaction costs in the tax efficiency every time we are making any kind of trade.
MARK: Chuck, often on this on this show we're talking about decision-making biases that people have that affect their financial decisions, often in a negative way. It would seem to me that, given passive fund management, index fund management, is very rules-driven, there probably aren't a lot of these cognitive and emotional biases that get in the way of the process when you're managing money. Is that fair to say?
CHUCK: Yeah, Mark, I think that's very fair. And it's really a great question because I think of biases as a potential nemesis of a passive portfolio manager. For us to tightly track the performance of our indexes, we have to be very disciplined and follow a very disciplined process. However, we're all humans, right? And we're investors. We follow markets. We favor or disfavor certain stocks, industries, countries. And following that disciplined process may have us buying or selling securities in contradiction to our personal convictions at times. But following that process, having controls in place where one person isn't making a decision, helps us to prevent those biases from influencing our decisions.
MARK: As we're recording this, Chuck, we've come off of kind of a rough period in the markets, U.S. stocks down, you know, double-digit levels, same thing with international stocks. Is the process that you just described, is that pretty consistent? Whether we're in a bull market or a bear market, the process is what it is and it doesn't … you know, the goals don't really change; therefore, the process doesn't change. Or is there something about bear markets that give you something else that you've got to be thinking about and accommodating during your trading?
CHUCK: Yeah, I think, for the most part, the process doesn't change because there's not a direct effect on our process or decisions. However, what does affect us is investor behavior in those situations. If you think about bear markets, investors are tending to sell equity funds. This requires us to raise cash. And when we have to raise cash, often funds … if we're in a bear market, we probably just came out of a bull market, and the funds … the securities that we hold have significant unrealized gains. So it puts a greater emphasis on the tax efficiency when we are seeing investors liquidating out of funds.
MARK: Chuck, ultimately, you're accountable to the shareholders in your fund. How do you want them to evaluate whether or not you're doing a good job?
CHUCK: Yeah, I think the key is how closely we tracked our index. How close is our performance to our index's performance, and have we done that in a low-cost and low-tax-consequence manner?
MARK: So low taxes, or minimize taxes, keep costs low, track the index, those would be the big three.
CHUCK: Absolutely.
MARK: All right, Chuck, last question. What's something that you've learned in kind of your career in managing these funds that is kind of applicable to people in their own portfolios, either some of the decisions they make or the processes that you're following?
CHUCK: Yeah, Mark, I probably sound like a broken record because I'm going to say following a disciplined process. Getting into this career has taught me to be very disciplined in a lot of decision-making. And I think that's a key for individuals. If individuals create a plan and they follow that plan in a very disciplined manner, I think they're most likely to reach their goals, just as I'm most likely to reach my goals as an index portfolio manager, and they're able to do it with a least amount of stress. And, you know, similarly, in my role here, if I follow my processes and I'm very disciplined, I don't mis-track my index, and, therefore, I don't have stress.
MARK: Chuck Craig manages international index funds for Schwab Asset Management. Chuck, this has been great. A lot of great, helpful advice on an area of the markets where, you know, frankly, I don't think there's a lot of analysis as to how passive funds actually operate. So this has been really illuminating. Thanks for stopping by.
CHUCK: It's been good to be here, Mark.
MARK: As I mentioned at the beginning of this episode, there's no one-size-fits-all approach when it comes to competing in sports or operating a business. It's also clear after those interviews that there are dramatically different ways of managing money. So which one is better?
I think it's best to take a step back and think of each investment, each fund you own, as performing a certain job. That job is one that contributes to achieving your goal as an investor.
We talk on this podcast about diversification a lot. It's also impossible to predict with precision the future, and because of that, it's hard to forecast with certainty which styles of portfolio management will work well. It makes sense to me to employ funds with a variety of approaches and understand how and when those approaches are going to add value over time.
It also makes sense to monitor those funds over time to make sure they're performing as expected and are continuing to employ the same investment strategy that attracted you to them in the first place. You also want to make sure that as your life changes that the funds you own still make sense given what you're trying to accomplish.
Finally, one of our most important investing principles is to pay attention to costs and taxes. Fees matter whether you're evaluating active or passive funds, and taxes are important if you're holding the fund in a taxable account.
To learn more about mutual funds that might be right for you, go to Schwab.com/FindMutualFunds. That's schwab dot com slash FindMutualFunds, all one word.
Thanks for listening. If you've enjoyed the show, please leave us a rating or review on Apple Podcasts. And if you know someone who might like the show, please tell them about it and how they can also follow us for free in their favorite podcasting app. You can also follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E.
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.
[1] Growth at a reasonable price
[2] Earnings before interest, taxes, depreciation and amortization.
