We have all heard the arguments about the flaws of active management and we all should have looked closely at the underlying data. Over any random 12-month period, about 60 percent of mutual fund managers underperform. Lengthen the time period examined to 10 years and the proportion of managers who underperform rises to about 70 percent. Even worse, equity managers who underperform do so by roughly twice as much as the outperforming funds beat their chosen benchmarks and the success of the outperformers doesn’t tend to persist. The SPIVA Scorecard from S&P demonstrates this phenomenon regularly and routinely.
Institutional investors fare no better. On a risk-adjusted basis, 24 percent of funds fall significantly short of their chosen market benchmarks and have negative alpha, 75 percent of funds roughly match the market and have zero alpha, and well under 1 percent achieve superior results after costs—a number not significantly different from zero in a statistical sense. Pension funds, hedge funds, endowments and private equity funds all provide similar outcomes in slightly different settings.
Meanwhile, and not surprisingly, assets are following performance. Just a decade or so ago, passive investing was a relatively small slice of the investment universe. On November 1, 2003, just 12 percent of all U.S. open-end mutual fund and ETF assets (not including fund-of-fund or money-market assets) were invested in passively managed products, according to Morningstar. Today that percentage stands at 27 percent and is growing fast. In the equity markets, fully 35 percent of all investments are now held in passive vehicles.
The obvious conclusion from all this data is that active management has lost. Sure, most money is still placed with active managers (at least for now), the story goes, but active management is like Nazi Germany after D-Day. The war wasn’t won (yet) and a lot of work remained to be done, but the outcome was inevitable. That narrative is prevalent throughout the investment world.
However, and to the contrary, I think active management is an absolute necessity. Continue reading
Charles D, Ellis is a really smart guy — retired academic, founder of Greenwich Associates, former Investment Committee Chair of the Yale Endowment, and the author fifteen books, including two of particular import. These two books are Winning the Loser’s Game: Timeless Strategies for Successful Investing and The Elements of Investing (with Princeton’s Burton G. Malkiel).
Ellis sat for an interview with Consuelo Mack recently (it may be seen here). As most of my audience will know, Ellis is a proponent of index investing for individuals. Over the course of the interview, Ellis makes a number of interesting and provocative points.
- For individuals, everything begins with saving, and the earlier we start, the better (because “catching up is hard and keeps getting harder, the longer you wait).
- A few great investors (like Warren Buffett and David Swensen) can beat the market, but most don’t, which is why indexing is smart policy.
- The competition among the hoards of industrious and talented investors to outperform is vigorous, effectively cancelling each other out.
- A few investment firms have clients’ interests as central (such as the Capital Group, Wellington, T, Rowe Price, American Funds and Vanguard, but most are simply “commercial” and do not.
- Investors should diversify as broadly and deeply as possible.
- Commodities offer no economic productivity, making investment in them entirely speculative and to be avoided generally.
- A key to investing is simply to avoid mistakes, like panic selling and greedy buying (but doing so isn’t simple).
- Investors need accountability to someone who knows and cares about them.
- Individual investors need to “stabilize” their portfolios as they get older, usually by owning more high quality bonds.
The interview is well worth your careful attention. In essence, Ellis is making the case for careful asset allocation using low-cost index funds with regular re-balancing and adjustments as needed to keep the portfolio in line with one’s risk tolerance. This carefully articulated viewpoint leads to my statement of what I call “the Charley Ellis Challenge” — to the extent that you do not agree with or follow his advice, why don’t you and upon what evidence do you rely for not doing so?