By Howard Gold
Charles Ellis is an investing pioneer, having founded financial-consulting firm Greenwich Associates in 1972 and written an early defense of index investing, “Winning the Loser’s Game,” whose eighth edition was published recently.
He also served as chairman of the Yale Investment Committee.
In this interview, he discusses why passive investing is a better bet than ever and shares some thoughts on the legacy of his recently deceased friend, the great investor David Swensen of Yale University. It has been edited for length and clarity.
Howard Gold: “Winning the Loser’s Game” was first published in 1985. I interviewed Nobel Prize winner Eugene Fama , whose paper that established the efficient market theory had been published maybe 10 or 15 years before that. The late John Bogle was just getting under way at Vanguard. Thirty-six years later, has passive investing finally won the battle?
Charles Ellis: It certainly is winning the battle. Every investor should be an active investor in the sense of actively figuring out who they are, what their circumstances are, what they’re trying to accomplish, what they’re trying to avoid, what will work for them [as a] long-term investment even as markets go up and down.
Gold: What specifically has changed? You mentioned in your book that institutions dominate the market even more. I think you had a figure they represent 90% of trading volume, but that’s really a huge change from, say, 40 to 50 years ago, when the model was buy good individual stocks that pay dividends and that’s how you would get rich, right?
Ellis: If you go back, the amount of trading done by individual investors was roughly 90% of all the market activity. Those individual investors bought or sold for reasons completely outside of the market itself. I got a bonus, I made an investment. My son’s going off to college, so I took money out. Then, half of the transactions by individuals were in AT&T common stock. [Institutions also tended] to be cautious, conservative and careful. And that means you [bought from] a list of maybe 30 or 40 major blue-chip stocks [and held them] for the long, long, long term.
Gold: And now it’s the complete opposite — institutions dominate the market and engage in rapid-fire trading. In the book, you said that over 15-year periods, some 90% of active funds underperform the indexes. And as Gene Fama told me, the key is predictability. You don’t know at the beginning of those 15 years which 10% of funds are going to outperform and which are going to underperform, right?
Ellis: That is terribly true, [but] there is a nice, easy solution to the problem. If you ask most investors, how would you like to be able to describe your investment [performance] 10 years, 20 years, 30 years from now, most people would say, “Honestly, if I could be top quartile, I would be thrilled.”
You can guarantee you will be in the top quartile. You’d probably be in the top half or one-third of the top quartile, but you’re guaranteed to be in the top quartile if you use indexing.
Gold: So, by buying what critics call “mediocre” index funds, you’re guaranteed to be in the top 25% almost by definition. Why don’t fund companies go all in for indexing? Are they run for their shareholders and employees, rather than for investors? Are they more concerned about growing assets and paying employees well enough to keep them than they are about market-beating returns or keeping fees down?
Ellis: I think that’s true. If you’re running a very large organization, you’re almost guaranteed to have as the senior executives managers with a commercial instinct rather than professionals with purpose, predilection or enthusiasm for investment results. And it’s very difficult for the commercial interest to appreciate what it takes to be skillful in the long run as a professional, and vice versa.
Gold: OK. So again, you think that average people, should really not invest in active funds and should exclusively put their portfolios in index funds or exchange traded funds (ETFs)?
Ellis: Well, if they want to do really, really well, index funds are a sure way of doing that. And if you do risk-adjusted return, you’re in the top half of the top quartile, then you are guaranteed to be a winner. That ain’t bad.
Gold: What has changed in the past, say, 20 years to make it harder for active managers to beat the indexes?
Ellis: Every major trend that I know of has worked to make it harder and harder for active managers to do better than the index. Regulation FD for fair disclosure [adopted by the SEC in 2000] says any publicly listed company must make a diligent effort to get the same information to everybody. The absolutely wonderful Bloomberg terminals are everywhere and they give you any information you want, any way you want it, any time you want it.
If you go back 50, 60 years ago, a major securities firm might have had 15 analysts, but they would be mostly focused on finding “interesting” stocks for the partners, not for customers. Today, we have [hundreds of] analysts at every major securities firm. They’re all out there competing with each other for getting accurate, useful information into the hands of investors. But the consequence of the devices, computers and technology is that everybody knows everything all at the same time, everywhere. When you get that kind of talent back and forth, with that kind of information, and the intensity of competition, it doesn’t leave much room for nice people like you or me.
Gold: Or nice people like MarketWatch readers who are trying to invest for retirement or for their kids’ college education, or whatever. You talked about whole-picture investing in your book, and we all have careers, we all have a way of estimating the value of that. You say that’s more important than trying to beat the market, that it will contribute much more to your financial well-being over time. Could you talk about that?
Ellis: Almost everyone makes the simple mistake, and that is to look at the investment portfolio as though it was the total picture. And it’s not. For most people, yes, they’ve got a securities portfolio, but they also have a home, there’s value in that home, and it doesn’t go up and down with the stock market. So you’ve got a diversification and a stabilizer at the same time. If you look at Social Security, it is a pretty darn valuable asset if you do the calculation to its present value, and it does not go up and down with the stock market.
Gold: It’s the best annuity you can get, right?
Ellis: From the best credit that we know of in the world.