This content is from: Corner Office

‘Seven Years of Being Just Tortured’: Why This Longtime Active Management CEO Started an Index Firm

Former Third Avenue CEO David Barse explains why he moved into the world of passive investing with his recently founded index firm XOUT Capital.

When David Barse stepped down as longtime chief executive officer of mutual fund firm Third Avenue Management in December 2015, he had at least two years before he could make his next move in asset management due to a noncompete agreement. Shortly before his departure, he says Third Avenue was suffering from risky bets made by a high-yield bond fund, and its value-oriented stock funds had been struggling to beat benchmarks since the 2008 financial crisis.

“I was facing this constant war that I was losing to the passive strategies that were both outperforming and gathering assets,” Barse said in a phone interview. In his view, active fund management became all too difficult post-crisis. “It’s too hard to do,” he said. “It’s really hard to pick winners, and it’s really, really hard to do that consistently.”

Last year Barse moved into the world of passive investing with the creation of his firm XOUT Capital. He concluded it’s probably easier — and more important — to focus on what to leave out from a portfolio than what to include. So, he built an investment formula that seeks to identify the losers among the 500 largest U.S. stocks based on market value, with a particular focus on technology risks that companies are facing.

“If you’re not addressing that then you’re going to get left behind,” he said. “What matters is how fast a company’s growing and what kind of moat it’s building around itself that will accelerate it past the competition,” he said. “Forget about the traditional valuation metrics.”

The selection process for his firm’s investment model doesn’t start with the Standard & Poor’s 500 stock index. Barse explained that XOUT’s constituency of 500 U.S. large caps has 90 companies that are not found in the S&P 500, including electric carmaker Tesla. He’s having some early success.

GraniteShares XOUT U.S. Large Cap ETF — the exchange-traded fund that tracks the performance of the XOUT US Large Cap Index developed by Barse — has gained 32 percent since its inception on October 7. It’s beating the S&P 500 this year.

The ETF, which trades on the NYSE Arca under the ticker XOUT, has risen 19 percent in 2020 through August 26. That exceeds the S&P 500’s gain of 7.7 percent over the same period.

“Each quarter we rebalance,” Barse said, explaining that XOUT considers seven factors in its scoring system. For example, JPMorgan Chase & Co. was knocked out of its portfolio in January because it “scored poorly” based on XOUT’s formula despite spending a lot on technology — and the bank has not made it back into the firm’s index.

“Going into the pandemic it’s been a great call because the big banks have not performed well,” he said. Slowing deposit growth might hurt banks’ chances of being included in his XOUT’s index, according to Barse.

Bank of America Corp. was added back into the index in July, he said, after showing “sufficient improvement” in its scoring. Wells Fargo & Co. has not yet scored well enough to be included in XOUT’s portfolio, Barse said.

[II Deep Dive: How Many Funds Outperformed in 2016, 2017, 2018, and 2019? Less Than 13%.]

Barse founded XOUT in April 2019, with the view that ETFs were the way for asset management to keep growing. “It’s the fast-growing part of the industry,” he said. Active managers are “going to continue to be challenged.”

Recent Morningstar research has some of the latest evidence that active managers are struggling. The firm said in a report this month that “actively managed funds have failed to survive and beat their benchmarks,” particularly over the longer term. Morningstar found that just 24 percent of active funds exceeded the average returns of their passive rivals over the decade through June. 

“Long-term success rates were generally higher among foreign-stock, real estate, and bond funds and lowest among U.S. large-cap funds,” Ben Johnson, director of global ETF research at Morningstar, said in the report. 

Barse, who had been CEO of Third Avenue for about 25 years, said he had a “fantastic experience” at the mutual fund manager up until the financial crisis. The period that followed was painful, partly because “value became almost uniformly value traps,” he said. 

It was “seven years of just being tortured — watching our strategy fail consistently, being outperformed by passive indices, seeing flows of capital being dominated by the passive indices,” said Barse. He doesn’t see much of a future for traditional active management.

“Just give it up,” he said.

Related Content