It always amazes me when people make the case for actively managed investment funds. If you understand the evidence against active trading — and in favor of index investing instead — it takes a heap of willful ignorance to keep believing.
I understand why, though. Often, proponents of active management are investors of a certain age who have done well at it in the past. I’m not going to deny that active once worked fine, only that it doesn’t work anymore, except for a tiny fraction of highly unusual investors.
But that’s a hallmark of great investment minds — the ability to recognize and embrace change. Charley Ellis, a former chairman of the Yale University endowment and a member of the Investment Committee of my firm, Rebalance, is one of those few.
His newest book is The Index Revolution: Why Investors Should Join it Now. In the book, which I highly recommend, Charley offers readers the facts about the changing world of investment management.
Charley is no academic, though he teaches at Yale. Rather, he is a pillar of the management industry, a former board member of the Vanguard Group and a sought-after advisor and investment consultant.
He’s also one of those old-guard professionals who saw the writing on the wall and instead of ignoring it, decided to accept it.
“Fifty years ago, only 10% of trading at the most on the New York Stock Exchange was done by professional investors, and they were not the greatest, fanciest professional investors,” Charley explains.
“It was insurance companies in Hartford, Connecticut, regional banks with their trust departments, all over the country, a few mutual funds in Boston, a few mutual funds in New York, one in Minneapolis. There wasn’t an awful lot going on.”
Something like 90% of trading was done by individuals and those individuals on average did a trade every year or two — typically because they got a bonus or inheritance and used it to buy stock, Charley says.
“What stock did they buy? Half the time it was AT&T, half the time it was something else,” he says. “There were a few people who did trading on a regular basis but they were very, very small.”
Outside the market
Essentially, nobody was trying to even understand the market, must less actively trade it.
“Most people bought stocks when they had surplus money and sold stocks when their kids went off to college or they wanted to buy a home,” Charley says. “They were outside the market. They were not paying any attention to comparative prices. They didn’t know very much and nobody was telling them very much.”
Today, it’s not 9% of the market that is institutional trading, it’s 99%, he says, and those institutions are in the market all day, every day making comparative prices.
They’re trying to find any kind of an imperfection in price they can capitalize on, Charley says, and because you can only find a mistake if it is made by one of the other full-time professionals, it’s getting harder and harder to find.
“Used to be, back in the ’60s, the mistakes were made by individuals and they would last for months! I remember once watching DuPont drop 50% in price for reasons that were clearly predictable,” Charley says. “It was shooting fish in a barrel. Really easy.”
Today, however, investors all have access to the same information because everybody has the Internet. Worldwide information is yours instantaneously, all the time.
On top of that, federal regulation means that information today is released to all investors at once. Add to that the sheer number of investment professionals now in the business. “When I first got into the field 50 years ago there might have been 5,000 people who were involved in active investment management,” Charley says.
“There are now at least 500,000 and I would bet closer to 1 million people, one way or another, directly involved in trying to figure out errors and mistakes in pricing made by any other investor, who will always have to be one of those other professional full-time investors. That’s not an easy place to make any money.”
Why index investing
But, you might say, what about those funds that do beat the market? Surely they have some secret sauce, some inside information? Not really. In fact, beating the market now is mostly a matter of random chance.
In Charley’s class at Yale, he asks the students to take out a coin and toss it. Some are heads, some are tails. They then repeat the toss, with only those getting heads continuing to toss their coins.
“Pretty soon you get down to 10 or 15 or 20 coin tosses and there’s somebody who’s still doing it. All heads,” Charley says. “And you ask him, ‘How are you doing that?’ And there’s an enormous temptation for that individual to say, ‘Well, I hold in my thumb a particular way and I throw it.’ That isn’t what happened. What happened is just normal statistics.
“If you look at investment returns, and you think I’m going to really steel myself and I’m going to just look for random behavior, it will explain an enormous fraction of the bad results and the good results, just random statistics.”
Index investing removes the random chance illusion that “doing something” will result in a better return. The data shows that taking an active stance in investing results in a loss vs. the market itself 80% of the time.
That doesn’t mean the other 20% of investors “know something” about stocks. It just means they came up heads more than once. In the next month, quarter or year, they’ll be back in the 80% of funds that didn’t beat the market and didn’t even keep up after fees and costs.
Index investing is fact-based investing. Three cheers for Charley for having the patience to lay it out all out for us to understand, and for bringing his considerable history and experience to bear on the matter.
