No Contest

Jonathan Clements

AS A YOUNG REPORTER in the late 1980s, trying to learn about investing, I read a slim 81-page volume with an unassuming title: Investment Policy. It remains one of the best investment books I’ve ever read.

Investment Policy was later reissued with a somewhat catchier title, Winning the Loser’s Game, and it’s now widely considered to be an investment classic. Over the years, the book has also been greatly expanded and the 2017 edition runs to 286 pages. Recently, I was in New Haven, Conn., and had lunch with the book’s author, Charles Ellis, now age 79.

Ellis recalls that, when he began working on Wall Street in 1963, outperforming the stock market was relatively easy for professional money managers. “The competition in those days was de minimis,” he says.

Much has changed in the five-plus decades since then. Financial information has become far more readily available. The number of money managers and analysts has exploded. Professional investors, who were responsible for maybe a tenth of trading volume in the 1960s, now account for almost all stock market activity.

Perhaps the biggest surprise: The cost of active management has climbed sharply since the 1960s. A 1962 study conducted for the SEC found that funds charged average annual expenses of 0.5%, and noted that this was “substantially higher” than the fees they charged their non-fund clients. Indeed, Ellis says that, at the time, bank trust departments typically charged just 0.1% of assets per year—a limit often set by state law.

Today, by contrast, many money managers levy 1%, with hedge funds often taking 2%, plus 20% of profits. Thanks to those high fees, money managers need to perform well just to keep up with the market averages—and do so in a market where their competition consists almost entirely of other professional money managers.

Put it all together, and the case for indexing is stronger than ever, as Ellis makes clear in his new book, The Index Revolution. Today, you can purchase total stock market index funds charging less than 0.05%. That would be a nice cost savings if the alternative was a 1960s bank trust department that charged 0.1% a year, or twice as much. But in today’s world, where the alternative might be an actively managed fund levying 1%, or over 20 times more, index funds look like an unbelievable bargain that only delusional, wildly overconfident stock jockeys would shun.

Still, Ellis isn’t predicting the end of active management—or worried about the day when widespread adoption of indexing threatens the functioning of the market. Even if investors move dollars from active management to index funds, driving down compensation for active managers, he believes the competition will be as fierce as ever. Active management is “fun, it’s interesting, it’s almost narcotic,” he says. “Nobody will quit voluntarily.”

I asked Ellis about passive investment strategies designed to outperform the market, commonly known as smart beta. He expressed admiration for Dimensional Fund Advisors, which has been a pioneer in this area, particularly with its focus on small-company stocks and value stocks. DFA, based in Austin, Texas, sells its funds through approved investment advisors.

But Ellis also worries about the amount of money currently being thrown at smart beta strategies. “It’s seductive,” he acknowledges. “You feel safe because you’re indexing, but you still have that chance to do better. I think there’s a large number of people who will be disappointed.”

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