For me, Charley Ellis is one of the investing world’s great consumer campions. In the mid-1970s, he became the first industry insider to acknowledge that most active fund managers fail to beat their benchmarks and that investors are far better off using low-cost index funds instead. His central argument was that the rarity of consistent outperformance combined with the significant long-term impact of fees and charges meant that active investing was, to use his own phrase, a loser’s game.
I recently caught up with Charley at a Financial Market History Workshop hosted by the Newton Centre for Endowment Asset management in Cambridge and found that, 40 years on, he believes the case for using actively managed funds is weaker than ever before.
He has nothing against fund managers, most of whom he says are “extraordinarily talented.. and wonderful people”. The problem, he says, is that there are now so many talented managers out there that it’s become almost impossible – even for the very brightest – to outperform their peers with any degree of persistence.
RP: It’s long been your view that active fund managers charge too much. Yet their fees – at least in percentage terms – seem relatively modest. Can you explain that?
CE: Well, fees are very small as a percentage of assets, but actually that’s not the right way to frame it. Fees as a percentage of assets are usually described as a four-letter word and a single number. The four-letter word is ‘only’ and the single number is 1%. But let’s reframe it. What is the fee in dollars or pounds? Well, it depends on what the returns will be. What’s the expected return from here forward? Many people would feel that the consensus was around 7% returns. The same 1% of assets as a percentage of seven is 15%. And if you’ve said 15%, you’ve dropped the word “only” because 15% is pretty substantial.
RP: So what sort of value do active managers add in return for what they’re charging?
CE: If you say, Wait a minute, there is a product called an index fund that will give me the market rate of return with the market level of risk – guaranteed – week after week, month after month, year after year. If I chose an active manager, it’s to get the incremental return that can be delivered over and above the market, right? And what would be the fee for that incremental return? 1% versus 10 basis points for an index fund is an incremental fee of 90 basis points. So, what is the incremental return that I will get for that incremental 90-basis-point fee? The answer is, actually, it’s not an incremental return. If you use the data that is reported, it looks to be somewhere between 50% and 150% of the incremental value being delivered by active management.
RP: In your presentation at Cambridge you said that “the game is over for active fund managers” – or at least for active managers charging as much as they do today. Why do you think that?
CE: When I came out of business school in the early 1960s, there was one course on investment administration at the Harvard Business School. There were no courses on investment management. Only two of us went into the investment management world. I did, candidly, because I didn’t find an alternative job. The two of us went to Wall Street. The next year there were three or four. By the time a decade had gone by, there were 50 or 100 coming in every single year. There has been a flood of extraordinarily ambitious, talented, well-educated, knowledgeable people coming into investment management. Those individuals, now a couple of hundred thousand of them, all over the world, are all competing, all trying to figure what the price of every single security ought to be, and they’ve done a very good job of it. The chance of doing better than all the others is getting less and less and less, but the fee has stayed high, so that incremental fee is hard pressed to earn its way with the incremental return.
RP: So why do you think so many people continue to put their trust in active management?
CE: The problem for most people, I think, is they just don’t recognise how very many people there are who use the same kind of computers, have access to the same kind of staff, have Mike Bloomberg’s wonderful system for gathering data and information anyway you want it, use the same securities analysis and get the same information from all of the companies. There were a whole bunch of factors that 50, 40, 30 years ago really differentiated the winners from the others. But now there’s no differentiation because everybody has the same information.
RP: To what extent do you think active managers themselves acknowledge – if only privately – how hard it has become to justify their fees?
CE: I don’t think there’s very much recognition at all. Who would want to recognise it? The business of investment management is great fun, it’s very fast-paced, very competitive and these are very aspirational people. It’s a wonderful line of work, where you work with the most wonderful people. The only part they have left out is how many other really wonderful people are competing with them all day, every day, and were there ahead of them and will be there right behind them, figuring out the same question: What’s the right price for each one of these securities?
RP: So you think they still strongly believe in what they do?
CE: It’s very hard to recognise this problem when you’re working very, very hard and you know you’re really talented and you are deeply committed to it, you get paid very well for doing it, and people look to you with great admiration and respect. It’s very hard to say, “You know, what we’re doing just doesn’t work”.
Let me give you another example. If you look at medical care up until about 1950 to 1955, doctors practising medicine did more harm than good. Iatrogenic disease was more cause for ill health than medicine and physicians’ attention helped people positively. Somewhere around then, science transformed medicine, so that today there’s a real advantage. Physicians actually do extend and improve lives. That’s a wonderful change. Investment management is going the other way, because there are more and more people trying to draw, from the same limited opportunities, a chance to do comparatively better.