When Average is Superior
Charley Ellis is the former chairperson of Yale’s investment committee and a well-known investment consultant. In 1975 he authored his now famous paper “The Loser’s Game.” He concluded his introduction with these humbling words:
Psychologists advise us that the more important the old concept of reality is to a person – the more important it is to his sense of self-esteem and sense of inner worth – the more tenaciously he will hold on to the old concept and the more insistently he will assimilate, ignore or reject new evidence that conflicts with his old and familiar concept of the world. This behavior is particularly common among very bright people because they can so easily develop and articulate self-persuasive logic to justify the conclusions they want to keep.
For example, most institutional investment managers continue to believe, or at least say they believe, that they can and soon will again “outperform the market.” They won’t and they can’t. And the purpose of this article is to explain why.”
Charley believed that the “old money game was over.” As financial markets and their participants grew in size and sophistication, the collective pricing power of the group became nearly impossible to beat. In most situations, one would assume that as the skill level of participants within a field increases, the outcome for consumers is positive. For example, as doctors become smarter, the quality of patient care increases.
In finance, however, the benefit we see comes in the form of a more efficient pricing mechanism. Better pricing does not directly translate to better returns for investors. As market participants become better at pricing, the likelihood that any one participant can outperform the collective group is greatly reduced. This means that investment managers who claim an ability to outperform the market, are actually becoming more likely to underperform. This phenomenon is referred to as the paradox of skill.
Charley Ellis identified this problem over 40 years ago. He became one of the early advocates of indexing strategies and still carries that torch today. While many have come around to his way of thinking (including myself), indexing still represents only about 30% of the total investment dollars.
As a follow-up to his paper, Ellis released a now classic investment book “Winning the Loser’s Game.” He expanded on the points of his early paper and focused on helping investors set realistic expectations. If you only read one book about investing in your life, this would be a great choice.
Last fall, Ellis published his latest piece, “The Index Revolution: Why Investors Should Join it Now.” Here he dove deeper into why he believes indexing is the most powerful strategy available to investors. Some will complain about Ellis’s tendency to repeat the same points over and over again. There’s truth to that but I think it is a good thing. It speaks to Ellis’s conviction and his points are worth repeating. He has been banging the indexing drums for over 40 years and there still are not enough people listening.
As Charley states in the book, “some people say that if you accept market returns (as you do with indexing), you are accepting mediocrity. You’re not; you’re accepting superiority.”
The entire book is worth reading but here are some points that he really drives home (emphasis my own):
- Betting against the collective wisdom of many thousands of professional market participants is likely to be a “loser’s game.”
- The skills and concepts of “performance” investing no longer work. In a profound irony, the collective excellence of active professional investors has made it almost impossible for any of them to succeed – after fees and costs – at beating the market.
- Indexing means accepting that active professionals have set security prices about as correctly as is possible.
- Nobody will ever know just how much harm was done by wrapping the term “passive” around indexing, but it certainly was not trivial.
- The curse of active investing is not simply that it reduces returns, which it usually does, but that, with so much complexity it diverts our attention from the profoundly important long-term investment policy decisions on which all investors should concentrate their time, energy, and thought.
- It is at least possible that the talented, competitive people attracted to investment management have, however unintentionally, gotten so caught up in competing for the tangible prizes that they are not asking potentially disruptive questions about the real value of their best efforts.
- Beliefs are strong – particularly beliefs we want to believe in.
- The simplicity of indexing is its great power. It eliminates or reduces all the “little” things that, like termites, eat away at returns: high fees, costs of trading, costs of changing managers, taxes, errors in the selection of managers, and more.
- One major benefit of indexing is that it is not interesting. If anything in the process is “interesting,” it’s almost surely wrong. That’s why the biggest challenge for most investors is not intellectual; it’s emotional.
- Indexing makes sense because indexing works. It is the only strategy that effectively guarantees that investors will earn their fair share of whatever returns are provided by the stock and bond markets.
- Factor-based or rule-based investing can work over the long term if either of two characteristics are demonstrated: (1) investors as a group are persistently biased or repeatedly make mistakes in ways that create persistent opportunity, or (2) a specific investor has an exploitable competitive advantage in information or understanding of factor-based investing. Operationally, investors trying to exploit the various factors need to be of sufficiently great skill and small scale in their activities that they don’t change prices enough to offset the potential factor advantage.