24 April 2017

The man who blew the whistle on the loser’s game

There have been some highly influential figures in the evolution of investing over the last 50 years. They include Jack Bogle, the founder of Vanguard who introduced the first retail index fund; the Nobel Prize-winning economists William Sharpe and Eugene Fama; and, of course, Warren Buffett, who despite being an active stockpicker himself, has consistently recommended that investors stick to low-cost, passively-managed funds.

But someone else whose contribution should not be under-estimated is Charley Ellis. In 1975, Ellis authored an award-winning article, ‘The Loser’s Game’, which in turn formed the basis of a book, Winning the Loser’s Game. In the article he famously said: “The investment management business (it should be a profession but is not) is built upon a simple and basic belief: professional money managers can beat the market. That premise appears to be false”.

Charley’s arguments have stood the test of time, and he is today one of the most highly respected investment consultants in the world.

In this interview, he discusses his latest book, The Index Revolution: Why Investors Should Join It Now, as well as the changes taking place in the investing industry. He also has some valuable advice for new investors.

Why did you write The Index Revolution, and what are you hoping that readers take away from it?

My main hope is that investors will recognise that the markets have changed enormously over the past 50 years and wise investors 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 caring to the really important work of defining their real long-term objectives and their ability to stay the course during market ups and downs.

You explain in the book how, when you started out in the asset management industry in the 1960s, you genuinely believed in the value of active management. But you came to realise that it doesn’t deliver anything like the results it appears to promise. When did your first doubts 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. Fifty 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. Fifty 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 (US Securities and Exchange Commission) requires all public companies to make sure that any useful information is distributed simultaneously to all investors at the same time. 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 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.

Throughout your career you have stressed again and again the importance of investment fees. Why is 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%!

Over the last couple of years we have seen huge outflows from active funds, and into passive funds, particularly 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 that the markets will have enough mistakes in pricing to mean that 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.

Last year we saw a large number of funds, especially hedge funds, go to the wall. Do you expect to see the fund industry contracting further 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.

Final question: what would your advice be to, say, someone in their 20s, who’s starting to think about investing? How should they go about it?

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 and focus on the long term, 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 markets seem scary.

At Carbon, we believe that patience is a virtue. That’s why our seventh investment principle states that “Investing is a long term discipline. Anything else is just speculation”. It would appear that Charley agrees.

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