Of all the speakers at November’s Evidence-Based Investing Conference in New York City, perhaps none has done has more to advance the evidence-based approach than Charley Ellis. He was himself an active money manager, but he worked out in the early 1970s that although fund management companies and other intermediaries stand to gain from it, for ordinary investors active management is, to use his famous phrase, “a loser’s game”. In this exclusive interview with The Evidence-Based Investor, Charley discusses his long career in finance and his new book, The Index Revolution: Why Investors Should Join It Now.
Burton Malkiel has called your book “the most financially rewarding two hours you could possibly spend”, which is praise indeed. What are you hoping that readers get out of it?
My main hope is that investors will recognise that the markets have changed enormously over the past 50 years and will want to understand things as they are, not as they were 50 years ago, and to act sensibly in their own interests. My second hope is that as investors index the daily, monthly, annual operations of investing, they will devote time, energy and care to the really important work of defining their real long-term objectives and their ability to stay the course during market ups and downs.
In the book you describe a personal journey you’ve been on over more than 50 years — from genuinely believing in active management to being a staunch advocate of index funds. When did your first doubts about active management begin to set in?
My first doubts for individual investors came in 1972 which is why I wrote the article The Loser’s Game. Back then, I still expected the pros to get superior returns. But, as more and more splendid people got into investing, it got harder and harder for the professionals to “beat the market”, because that meant beating other pros. 50 years ago, professional investors were 9-10% of all market activity. Today, they are 99% of listed trading and 100% of the even larger derivatives market.
Added to this is the fact that the secret sauce of active investing has always been to get an advantage on information. 50 years ago, that was easy. Guys like me would study and analyse information for 3-4 weeks and then go visit the company for 2-3 days and interview several executives, who would gladly answer all our questions so we would really know what was going on. Today, that is long gone. The SEC requires all public companies to make sure that any useful information is distributed simultaneously to all investors at the same time. Poof, there goes the chance to get a competitive advantage on information.
Success (and high pay that came with the competition for talent) attracted lots of people who also found the work was exciting and fun, that you learned a lot about all sorts of subjects, that the people involved were interesting and great to work with, and that everybody admired professional investors. Later, we also learned that while traders retire by 45 and investment bankers quit by 55, investment managers could continue into their 80s, so career competition was even greater.
Something you have always stressed is the importance of fees, and how although they look small in percentage terms they are in fact very significant. Explain that.
As a percentage of annual returns of around 7%, a fee of, say, 1% is very high. Investors can now get the market return at no more than the market level of risk for 10 basis points with an index fund. When they pay up to 1% or more incrementally, what incremental return do they get? The record, with deleted failures restored for fairness, shows that over 80% of funds fall short of their chosen objectives. So, hold your hat, fees for active investing are actually more than 100%!
There have been huge outflows from active funds, and into passive funds, in the last couple of years, at least in the US. If this trend continues, do you think it will create more opportunities for active managers to outperform?
Everyone seems keen to learn when indexing will be so large that active investing can make a comeback. Here the real question is, When will enough people quit active investing so the markets will have enough mistakes in pricing so capturing those mistakes will once again be fairly easy? First, it is not a red or yellow line that will apply to all. Each active investor will make her or his own decision and they will do so in a wide spectrum. My guess is something like 80-90%.
You’re not a fan of so-called smart beta. Why is that?
Smart beta is such a clever name — second only to the clever Scots who changed the name of death insurance to life insurance. The guy who came up with it has already made a large fortune on the name. Portfolio insurance was another clever name until it failed miserably.
There are factors that can be identified and experienced specialists with great skill can here and there exploit these ephemeral opportunities. But most offerings are likely to attract the most interest when the case looks best: unfortunately that will be after the best opportunity has passed, so most of the money going into such products will miss the positive and, as that area of the market inevitably regresses to the mean, that same factor will surely underperform. It cannot do better forever.
Do you see the fund industry contracting over the next few years?
The number of active mutual funds will probably decline over time. After all, we now have more funds than stocks! Every year, funds disappear, but new funds get created because the fund business pays so well, not for investors, but for the fund management companies.
Finally, what would you to say to someone in their 20s, who’s starting to think about investing? What should they be doing?
When advising young people, I urge them to ponder the long-term compounding advantage of index funds and to recognise that their investments will be invested for 50 or more years and that with such a long, long time horizon, if they can live through the fluctuations, they will invest almost entirely in stocks. If they will be working, the net present value of their earned incomes (which are so predictable that they are more like bonds than any other securities) is so large that it dominates their total portfolio. So the only “reason” to own bonds now is to help protect them from misbehaving when market seem scary.
Why not come and hear Charley Ellis speak at The Evidence-Based Investing Conference in NYC on November 15th? To register, follow this link.