Unpacking Charley Ellis' 'defense' of active investing.
The Case Against
This month, Charley Ellis published "In Defense of Active Investing." The headline intrigues because Ellis is an indexing legend. In 1975, he wrote that active investing is"The Loser's Game." The article became an instant classic and was later incorporated into the curriculum for Chartered Financial Analysts candidates.
"The Loser's Game" argued that investment success lies not in hitting the most winners, as it's very difficult to strike winners while competing against hordes of other informed investors, but rather in minimizing the "losers" of turnover, costs, and taxes. (All right, taxes are my addition, as 1970s institutional investors never considered the subject, but Ellis would certainly have discussed them had he thought about retail accounts.)
That was not the conventional wisdom at the time, when the friction of costs was considered a minor drawback to the exercise of insight. Now, of course, Ellis' claim is a bedrock belief.
The defense article begins by outlining the history of the attack on active management: "First came the academics, armed with their arcane null hypotheses, statistical inferences, and long equations littered with Greek letters." This first wave of attack posed no practical threat. Ellis writes, "Active managers were certain that no practical men of affairs knew about--much less read--the obscure academic journals in which those in the cloister read, publish, and reference each other's articles."
(Ellis knows the secret: Institutional investors don't much read the academicians whom they reverently intone.)
"Then came performance reporting and all sorts of odious comparisons. Fortunately, as Nate Silver continues to explain, the numbers we see combine both the signal and the noise in a never-ending cloud of mystery that invites manipulation: Change the base year, change the benchmark or standard of comparison, or report gross of fees rather than net. [The latter is no joke; that remains the standard reporting structure for the separately managed account business.] Or, in especially awkward situations, explain that certain disappointing people have been replaced, so all will now be better."
Such evasions, explains Ellis, have come under pressure from comprehensive studies that avoid the anecdote. These reports show that "a majority of their funds fall short of their benchmarks and that the trend is toward larger proportions of actively managed funds falling short and that the magnitude of underperformance substantially exceeds the magnitude of outperformance."
Then arrived the attack of active share. The invention of the active share measure initially seemed to help the cause of active managers, as the numbers suggested that the more-active managers fared better, but that finding has recently been called into question. Also, as Ellis points out, the existence of the active share score suggests the troubling math: A fund that has a 25% active share and a 1% expense ratio effectively charges 4% on the fourth of assets that it does not index. It's very difficult to overcome a 4% annual hurdle!
This newfangled idea of viewing the expense ratio as paying only for the part of the portfolio that is different than the benchmark, rather than for the entire portfolio, can also be extended to performance. If the stock market returns 5% in a given year, a fund with a 1% expense ratio should not be regarded as having taken 20% of the profits. Because that 5% could be purchased (almost) for free via a market-index fund. The correct evaluation should be as "incremental fees relative to incremental returns," which becomes a "particularly odious comparison" as "the average active manager is shown to be charging incremental fees that amount to more than 100% of the incremental returns--before taxes."
(Ellis also relates how investors hurt themselves by chasing 5-star actively managed funds, but in that he is mostly wrong. The big problem for fund investors lies not in swapping funds within a given category, which causes little harm because the returns for funds within a category are highly correlated, but rather in dropping cold assets to buy hot assets. Stocks plunge in 2008! Sell stocks in 2009, buy bonds! That's how investors hurt themselves. And asset-class trades have nothing to do with star ratings, which measure only how funds perform within their categories.)
The Case For Against
You might wonder how Ellis rescues active management from that onslaught. The answer: He doesn't.
His main line of defense is that, although active managers generally don't do well for their shareholders, they deliver a great social good in creating highly efficient markets. Viewed in absolute terms, the (literally) hundreds of billions dollars spent each year on investment professionals looks ridiculous. But from a relative perspective, it's a modest price to pay for having the world's businesses accurately priced.
Because the benefits are tremendous. Efficient markets "encourage millions of investors to trust the capital markets with their savings." They reward stronger companies and penalize the weaker. They break down national borders, making for a "global megamarket," which has made for "faster growth, more and better jobs, more democracy, and better prospects for world peace." Active management has helped to lift "over 1 billion people out of poverty in just one generation."
Whew again! I have no idea if all that is true; however, at the least Ellis is correct that active managers perform a useful service in pricing securities. Unfortunately, even if Ellis' argument is completely and fully accurate, that's no reason to invest actively. So the world needs active managers. So as a whole they are useful members of society, not parasites. So what? Let others fund their noble venture. You and I will free-ride. We will index and let those suckers paying 1% per year teach the world to sing.
Ellis' secondary defense is similarly unconvincing. He writes that, although it's difficult to win the Loser's Game, it is also "hard to lose." After all, the corollary of the criticism that active managers mostly hold the market is that active managers mostly hold the market. The biggest success for any prospective investor lies in getting into the game. After that, the leakage caused by active managers is modest. Besides, investing actively is good entertainment. "Since active investing is exciting and fun, investors who are losing a bit in purely economic terms surely enjoy a significant social good by being part of the action."
At this point, I wonder whether Ellis is sliding into satire. He continues in the next paragraph, "Unrelenting attackers--apparently driven by the 'green grievance' of jealousy--curiously ignore the enormous benefits to everyone in our society that come directly from active investors' generous philanthropy. We should be more appreciative of active investors' services to society as leading patrons of the performing arts and as core benefactors of colleges, universities, museums, hospitals, and orchestras--and as major donors to political campaigns, which are so important to our democracy."
Now this is a man who has read his Swift.
With Friends Like Ellis ...
While I don't believe the case for active management is as hopeless as Ellis presents, as investors can improve their odds by seeking funds that share certain common attributes, I do not dispute his thesis. Active managers do set efficient security prices. They do help global markets to function smoothly. But there's no particular reason why you need to own them.
Ellis' "defense" of active management is in reality a highly effective attack. He came not to praise active managers, but to bury them.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.