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!