Why No One Is Better at Finding a Fair Price Than the Market

On this episode of The Long View, Charley Ellis, author, academic, and founder of investment consultant Greenwich Associates, discusses the landscape for active managers today, the potential paradox in index investing, his reservations around private capital, and lessons for investors from his latest book Rethinking Investing: A Very Short Guide to Very Long-Term Investing.

Here are a few highlights from Ellis’ conversation with Morningstar’s Christine Benz and Amy Arnott.

Why No One Is Better at Finding a Fair Price Than the Market

Christine Benz: In terms of what to invest in, of course you are a big believer in index funds and in index investing. You make the point in the book, and you made the point when we interviewed you previously, that active managers are more talented than ever, you believe, but beating the index is harder than ever. Can you address that, because on the surface it seems to be a little bit of a paradox?

Charley Ellis: It sure sounds like a paradox, but when you get to the facts of what’s going on, if you just look at investing since I came out of business school in the early 1960s, in those days at the most 10% of trading was done by institutions. Now it’s over 90% is done by institutions, and the institutions have transformed themselves from being mostly rather sluggish, slow moving, day with the blue chips, try to hold for the long term, laddered bond portfolios, trust department, all over the country—we had 14,000 banks in those days, 14,000 banks, and they almost all had a trust department. Sometimes the trust department was one person, but that was the institutional market. Today the institutional market is dominated by hedge funds, which have supersmart people, unbelievable technology equipment, and access to worldwide sources of information instantaneously. That’s really different, but if the big changes that go from less than 10% to more than 90% is done by professionals—that makes a tremendous difference to the nature of the market.

And the market has gotten more and more and more skillful at doing what markets are supposed to do, which is define a fair, accurate price, where buyers and sellers agree, you know, that’s about the right price. That strengthening, the process of pricing has made it harder and harder for anyone—even though they’re getting better and better than their predecessors could have—harder and harder for anyone to keep up with the standards of excellence that are in that marketplace. And the standards of excellence in our equity marketplace or bond marketplace today are simply astonishing. And given how good the markets are at finding the right price, it makes it harder and harder for any individual, even these really superbright people, to do better at finding the right price than the market does. And that’s where the curiosity or the paradox comes into play. Yes, the markets are getting more and more skillful at doing what markets are supposed to do because of all the participants getting better and better, but because it’s so darn good, it’s very hard for any individual or institution to do anywhere near as well as the markets are doing at finding the fair price.

How Reg FD Drastically Improved Price Discovery

Amy Arnott: So with all of the improvement that we’ve seen in price discovery, would you point to Reg FD, which has been in place for about 25 years now, as one of the reasons behind that? Or are there other factors that you would point to that have driven improvements in price discovery?

Ellis: Great question. And the right answer is you bet. Regulation Fair Disclosure, or Regulation FD, is the SEC’s regulation that no publicly owned company can offer information to any one investor that they don’t make a simultaneous effort to get that same information available to all investors. The obvious answer for the corporations is hold regular 800-number dial-in conference calls, usually once a quarter, and give everybody exactly the same information at exactly the same time. And that’s it. Years ago when I was first getting the investment management business, the whole game was about do your homework, then make a corporation contact and either the chief executive officer or the chief financial officer would talk to you. If you had done really good homework, they would talk to you much more candidly and openly and give you all kinds of information about plans for acquisitions, judgments on new products, technology developments that were making a difference, what they thought about individual competitors.

All kinds of really nifty information on the basis of which you could make a judgment that was better than the market was able to evaluate the company. That was wonderful for those who had the private meetings with the corporate executives, but it wasn’t fair to the other investors who were not let in on the game. And therefore I think the SEC regulation—everybody on a level playing field—has been really important in terms of the integrity of our markets. It was a very, very sensible decision to make and has resulted in making it so that everybody knows all the same things at exactly the same time, and therefore you can’t get a competitive advantage.

Did Active Fund Performance Decay After Reg FD?

Benz: When you look at the data on active fund performance, does performance notably decay after Reg FD? Have you looked at that phenomenon of whether the performance edge that active funds might have had abates when that regulation goes into effect?

Ellis: Now I think it has, the differentiation that people had been able to accomplish has gone down very considerably. And that’s actually a very good thing because it means the average decision-making has gone up and up and up, and it’s more and more accurate. So that had been a terrific regulation that serves everybody who is playing fair really well. And I’m very glad we have it in our markets. And other markets around the world typically follow the US market with some lag. They’re all working in that same direction now, which is going to be good for investors generally everywhere.