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Charley Ellis: 3 Reasons Active Managers Lose Out

By Jane Wollman Rusoff

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A big secret to success in the stock market? “Ignore the beat-the-market hype of brokerage firms, actively managed mutual funds and investment letters from stock market gurus working in cahoots with Mr. Market. If you’re a serious-minded long-term investor, what Mr. Market does isn’t good for you.”

So argues Charles “Charley” Ellis, famed investment strategy consultant, in an interview with ThinkAdvisor.

He will release the eighth edition of his classic bestseller, “Winning the Loser’s Game: Timeless Strategies for Successful Investing,” (McGraw-Hill Education) on May 18.

Instead of active investing, the legendary consultant to big institutions and founder of Greenwich Associates, which he led for 30 years, strongly favors indexing and has done so ever since he wrote his doctoral dissertation at New York University.

In the interview, Ellis, 83, reveals the three major ways active managers lose: wrong asset mix, wrong stocks, wrong timing.

He maintains that compared to active management, for long-term investing index funds “guarantee” better returns, lower costs, lower fees and lower taxes. Those attributes are responsible for the striking increase in indexing’s popularity over the last several years, stresses Ellis, who earned his MBA at Harvard Business School and has been honored by the CFA Institute for lifetime contributions to the investment profession.

In our conversation, he opines on the bond market, ETFs and non-fungible tokens, or NFTs, the excitement over which reminds him of a certain infamous investing mania of 17th-century Holland.

His outlook for the U.S. economy remains bullish, unchanged from his forecast in an interview with this reporter last June. For one, he has expectations for resumption of strong consumer spending as soon as “the plague will be over.”

Ellis, who in 2016 published “The Index Revolution: Why Investors Should Join It Now,” is on Wealthfront’s advisor board and the investment committee of Rebalance. He was a successor trustee at Yale, where, with David Swensen, he chaired the university’s investment committee.

ThinkAdvisor recently interviewed Ellis, who was speaking from his Connecticut base. Remarking on how investors can be fooled, he stressed that manipulating emotions is Mr. Market’s M.O.

Here are excerpts from our conversation:

THINKADVISOR: What’s your view of NFTs — non-fungible tokens?

CHARLEY ELLIS: Some people made money in tulips in Holland too, you know.

What’s your thinking about exchange-traded funds?

I wouldn’t do an exotic ETF under any circumstance — taking a narrow focus and especially if you put unfortunate things, like leverage, on it. For instance, a gold ETF or a medical instruments ETF doesn’t make any sense to me.

Do you still refrain from investing in bonds?

Certainly. If you buy a bond today, you get a little less than 2% as cash income, and the Fed wants to have 2% inflation as a norm. If inflation goes up to 3%, bond prices come down. So you lose money on the capital side, and you break even with inflation on the income side. I don’t think of that as a very exciting, positive investment.

You’ve argued for decades that investment management is “a loser’s game.” How so?

Because when you’re competing to outperform, the dominant controlling variable will be the behavior of the loser. There are three ways of losing: having the wrong asset mix, picking the wrong stocks or bonds, and having the wrong timing.

So how have active managers performed over the last several years?

According to SPIVA [S&P’s Indices Versus Active Funds Scorecard], they’ve become gradually worse and worse over time. That’s because there are so many different forces that are making markets quote-unquote efficient — more accurately priced — or harder and harder to beat.

What are some of the forces?

One is volume of trading. When I first got to Wall Street in the early 1960s, 3 million shares a day was a huge day. Now it’s 6, 7, 8 billion shares. Another [factor] is that everybody knows everything today because all they have to do is go to a Bloomberg terminal and punch it out. And the SEC has said that if you’re a publicly listed company and give anybody information that might be useful, you must make a diligent effort to be sure everybody in your investment group gets the same information at the same time.

Is the manager’s mission to beat the market the root of the active management issue?

Hope is a very important part of all of us. There are certain things about human beings that are quite wonderful but don’t happen to be economically helpful. We’re trained in most ways that trying harder is better, such as in the story, “The Little Engine that Could”: “I think I can. I think I can.” And [she] made it to the top of the mountain. But trying harder isn’t always [the best way]. With some things, it just doesn’t work. 

In “Winning the Loser’s Game,” you write that “investing is not entertainment. Investing is a sober responsibility. Investing is not supposed to be fun and exciting.” Seems that during the pandemic, many folks who think they’re investing are really only in the market for fun and entertainment. What’s your take on that?

It’s true. And on average, they will have had very unfortunate results. The ramp-up of individual stocks in the last couple of months has gotten a lot of attention because it’s a unique phenomenon.

What did that entail?

People got excited about it, and some were very successful. So that got others excited. But nobody much reports, “Gee, I really lost some money. I’m so embarrassed.” The serious work of long-term investing, which is what investment advisors and professional investors are really all about, go past this kind of stuff and pay it no particular attention.

Why has indexing become so popular?

The amount of money that’s been moving year after year, after year, away from active investing and into indexing is stunning. There’s a very good reason for it: If you’re an investment professional wanting to guarantee to a long-term investor that they’ll get top-quartile performance, [you can tell them], “If you follow my advice and index, I can guarantee you’ll get top-quartile performance if you follow my advice, and I can do it for lower cost and lower fees than you’ve ever paid and with lower taxes than you’ve ever had. All you have to do is index, and you’ll be in the top quartile for 20, 30 years.”

You’re invested in index funds only with the exception of one individual equity. Please discuss.

Like a lot of people who are index-committed, every once in a while, on the side, I do a little stock purchase. It’s something [such] investors think is pretty damn interesting. For example, I’ve owned Berkshire Hathaway for 50 years — I’m happy with it. But I have to admit that I check the price of that stock almost every day. I might buy some more, but I certainly wouldn’t sell any.

“The first secret to success is to ignore the beat-the-market hype of brokerage firms, actively managed mutual funds and investment letters from stock market gurus working in cahoots with Mr. Market,” you write. In what way are they “in cahoots”?

It’s not deliberate or malicious. But if you’re a serious-minded long-term investor, what Mr. Market does isn’t good for you. His objective is to get you to do something. He doesn’t care whether you buy or sell. All he wants is for you to do something. Often he does all kinds of things to get your attention and take action. He likes to scare you sometimes. He likes to get you overconfident sometimes. Sometimes he likes to get you all excited about something. He’s always trying to catch your emotions so you’ll do something. Meanwhile, the dull workhouse economy plods along in its own particular way. 

Who came up with the concept of the Mr. Market analogy?

Mr. Market was invented by that wonderful man, Ben Graham [“the Father of Value Investing”], whom I knew pretty well when he was in his 80s. He was terrific. He invented Mr. Market because he wanted to show people that there are two fundamentally different things going on in the market [simultaneously].

Last June, in an interview with me discussing the coronavirus pandemic, you predicted: “We’ll come out of this darkness in a very powerful way.” Are you sticking with that forecast?

Yes. There’s going to be a terrific amount of not-yet-satisfied demand. I don’t know anybody who doesn’t say, “I’d love to go to restaurants again or [travel to] see my children or grandchildren or parents again.” A lot of people haven’t shopped for things, like clothing — so they’re likely to restock their closets. About two-thirds of the economy has been pretty good at saving during the pandemic because they’ve kept working. Others have had a terrible time, and that’s a shame.

When will all the spending commence? This summer? In the fall?

That’s easy: Tell me when the plague will be over and everybody agrees it’s time to open up and go back to our past activities. As more and more people get their shots — and I hope they do — we’ll be able to bring down COVID-19.

Jane Wollman Rusoff

@jrusoff2

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