Linden Thomas & Company
A Different Approach to Indexing
Five Deficiencies Investors Should Know About Indexing
In pursuit of improving traditional index investing, Linden Thomas & Company analysts conducted in-depth research to improve upon the strategy of using market capitalization-based index mutual funds. Because we feel it is our responsibility to help each client achieve the best portfolio results, we decided to investigate how traditional index funds work and how results for investors are achieved, as well as how results could be improved. Through our thorough research and developmental process, we found structural enhancements that could be made to traditional index funds for high net worth investors. By applying these changes, we can enhance long-term results. We were also surprised to find that most investors are unaware of the inefficiencies in traditional index mutual funds and are very interested to learn more. With that in mind, the Linden Thomas & Company team set out to build a more efficient index for our clients while also providing education and insights into the differences between traditional retail index mutual funds and our earnings quality indexes, held in a separately managed account (SMA).
Deficiency #1 – Lack of Quality
Most traditional indexes include companies based on market capitalization, not earnings quality. One example of such an index is the S&P 500, which is comprised of 500 of some of the largest publicly traded companies in the U.S. Because of this focus on market capitalization, indexes can pool together stocks of companies with high earnings quality with stocks of companies with low earnings quality as long as they all meet certain market capitalization requirements. By “earnings quality”, we mean highly profitable and financially sound. While considering market capitalization is not problematic on its own, holding companies that have poor earnings quality can hurt results and delay recovery during downturns, regardless of the underlying companies’ market capitalization. Our stringent earnings-focused selection process filters out unhealthy companies that may have economic constraints that are difficult to identify. Our earnings screens help identify possible delistings, bankruptcies, defaults, and declining earnings.
Deficiency #2 – Lack of Ownership & Control
Unlike traditional investment firms, where advisors broker products, we build our index portfolios through the purchase of individual securities in a separately managed account (SMA) vs. a retail mutual fund. This solution eliminates unnecessary costs and the pricing disadvantages of mutual funds. The separately managed account creates a portfolio that investors own outright. As a result, investors can easily monitor holdings and control both tax management and gifting of securities.
Deficiency #3 – Lack of Transparency & Costs
Mutual funds pool together thousands of investors. This leads to near-constant buying and selling, which adds to trading costs, as small investors move in and out. Many industry advisors do not fully educate their clients on the real impact of costs, tax efficiency and transparency. Some additional areas that may impact results include:
- Hidden trading costs
- Mutual fund style drift
- Hidden tax impact of portfolio turnover
- Portfolio overlap
- Small investor redemption impact
Deficiency #4 – Pricing Inefficiencies
Since most indexes are prescheduled to reconstitute (recalculate which companies are largest, based on market capitalization, and buy and sell accordingly) once a year, large institutions can buy and sell the securities held in indexes before retail investors and mutual funds can act on the same information. This creates pricing inefficiencies that can only be avoided through direct ownership in a separately managed account. In addition, since mutual funds are pooled accounts, many times major new events can cause individual investors to react with fear and greed. This pooled behavior can create panic selling and buying, short-term portfolio turnover, taxation and pricing deficiencies for investors that remain in the mutual fund index.
Deficiency #5 – Company Defaults & Delistings
Defaults and delistings are often the biggest contributors to poor results experienced in down-market recoveries and during economic slowdowns. This happens when an index fund delists companies that have dropped below its market-cap requirements. Then, the challenge is that the downside results of these same companies have already impacted the index’s performance. Because index holdings are based on market capitalization, not earnings, over time this can be a significant disadvantage to mutual fund index performance.
How We Build Better Indexes
Three Benefits of Our Approach-Quality, Control and Cost
Because of the inefficiencies we found in traditional market cap index mutual funds, our team at Linden Thomas & Company set out to build a family of earnings-quality separately managed account (SMA) indexes for our clients. The main aspects of a quality focused index SMA are:
- Quality focus
- Individual ownership/control
- Lower costs and full transparency
Benefit #1 – Quality Matters
We established earnings screens to help identify companies that meet quality of earnings requirements. When earnings screens were applied to traditional indexes it helped identify companies that should remain and companies to be replaced. Applied and back tested over time this has proven to enhance long-term results and help in down market recoveries.
Benefit #2 – Control/Ownership
Because traditional mutual funds pool investors with all sorts of personal needs and timelines, investors can move in and out of the fund which may create both phantom capital gains and trading costs. Mutual funds also do not buy stocks in your portfolio the day you invest. The influence of these types of mutual fund behaviors are rarely discussed with clients before or after investing. This not only hurts total returns, but it can also pass along capital gains to you that the mutual fund has experienced, even though you may not have made money in the fund. The Linden Thomas & Company Earnings Quality Indexes give each investor full ownership to reduce the impact of small investor behavior. Our indexes give you the ability to monitor each holding, manage capital loss needs through tax loss harvesting, as well as allow the gifting of securities that have large gains.
Benefit #3 – Lower Costs/Transparency
Because each Linden Thomas & Company Index holds individual securities, not traditional index funds, we can control trading costs through a flat fee. This provides total transparency and eliminates hidden costs that retail advisors often do not want investors to know about.
Our Earnings-Focused Index Family
We have been working with high net worth investors for the last 30 years. When it comes to long-term investing, quality, control, and cost do matter. We are proud that we can deliver indexes that are built with our client’s needs in mind. Each Linden Thomas index starts with the top publicly recognized companies in the United States. We then apply data driven growth/value measurements to select the best companies in each investment discipline. We then narrow our focus and construct the portfolio to ensure all sectors of the economy are represented in the index. Our quality focused indexes enable each investor to capture specific company characteristics within several broad investment themes. The three main index selection themes include:
- Small, medium and large company indexes
- Growth vs. value indexes
- Dividend focused indexes
Please reach out to us to schedule a complementary portfolio review or to learn more about our services via our contact form.