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Anomaly Ahead

Charles D. Ellis

COULD I BE WRONG about indexing?

Every investor soon learns that being wrong is a frequent malady, particularly on the day-to-day decisions of when to buy. Those minor errors are, as we also learn, part of the “game” of investing and are best ignored. But what if there’s evidence that conflicts with your longer-term thinking and expectations? What if evidence conflicts with your central beliefs?

I suspect it could happen to me.

After 60 years of experience and study of investing, and extensive dealings with many of the world’s outstanding professional investors, I came to a central conclusion many years ago. Smart as they are, hard-working as they are, superbly armed with the best equipment that technology can offer, and marvelously informed as they are, most expert investors are doomed to underperform the market for two simple reasons.

First, everybody still in the game is superb in every way, so experts can only buy from or sell to other experts, all of whom have the same access to superb and voluminous information at the same time. Second, the cost of trading, plus fees and taxes, are high enough to be virtually impossible to overcome long term by outperforming the collective expertise of hyper-competitive competitors who now dominate the market. (The stock markets of China, so far, continue to be the exception because they are still dominated by individual price-trend followers, sometimes called “willing losers.”)

As a serious student-observer of both the markets and investment managers for decades, I’ve been convinced that, over the long term, the best way to achieve the Holy Grail of top-quartile performance was simple: index. Most active managers would, due to fees and costs, underperform.

Now, I’m not so sure.

Here’s why: Among the 500 stocks in that most popular S&P index are a group of technology stocks with very high price-earnings multiples. They’re still called the “FAANG” stocks—for Facebook, Amazon, Apple, Netflix and Google—even though Facebook and Google have changed their names to Meta and Alphabet, respectively.

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It wouldn’t be surprising if these stocks, despite continuing business growth by the companies, were to have a pause or even a decline in their share prices. Since these stocks are under-owned by most active managers, the statistical result would be evidence that active management is back. We can be sure that this suggestion of a comeback would be widely celebrated by active managers. Well, they would, wouldn’t they?

So, what should I do now?

When heavy snows fell in late spring in Washington, D.C., climate-change skeptics celebrated the “hard evidence” against global warming. But climatologists cautioned that the unusual snowfall was a predictable part of their expected data, and actually confirmed global warming models.

As every statistician understands, long-term trends are chock full of short-term, out-of-pattern anomalies. In my view, the long-term reality continues to hold: Most active managers won’t be able to overcome the fees and costs of their operations by outperforming their competitors. That’s why I’m sticking with indexing and recommend all long-term investors do the same. I’m confident that I’ll be wrong again and again in the short run—but proven right over the long haul.

Charles D. Ellis is the author of 18 books, including Winning the Loser’s Game, which is now in its 8th edition, with 650,000 copies sold. Charley has taught investing courses at both Yale and Harvard business schools, and he served for 17 years on Yale’s investment committee. Check out his earlier articles.

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Asculpeous Zeno
Asculpeous Zeno
2 days ago

Thanks for your thoughts, and just enjoyed reading the latest edition of your book.
The big question is :would you put your own money into an index fund now?( assuming you had the money to invest)

B Carr
B Carr
3 days ago

Since some of the FAANGs have changed their names, should we refer to them as MAANA (as in, from Heaven)?

Scrooge_McDuck88
Scrooge_McDuck88
5 days ago

Charles- I have a few of your books and enjoy them very much. I too agree with indexing for all the reasons above. But, if memory serves me correct, the vast majority of your wealth is in the form of Berkshire Hathaway A shares that you bought in the 70’s and 80’s. An amazing move…when you have made the vast majority of your wealth accumulating and holding a single stock.

parkslope
parkslope
5 days ago

Bloomberg had an article 11 months ago titled: With Tech Oligarchy Shaken, Active Funds are Having a Great Time (Feb 21, 2021).

Does anyone know the extent to which active fund managers have “under-owned” the largest 20%-25% of the S&P stocks over time? I suspect that it hasn’t been that much less than the current situation with FAANG stocks.

Ormode
Ormode
5 days ago

The real problem would be all the 401K investors who have sworn to hold the S&P 500 in their accounts until they retire in 20, 30 or 40 years. If they have huge gains, they just might get cold feet and start selling when the S&P goes down 10%, 20%, 30%. Even a small amount of selling would accelerate the decline of the FAANG stocks, as they are disproportionately represented in these portfolios. That, of course, would cause the S&P to go down further, and more long-term holders to sell.

Daniel Knight
Daniel Knight
5 days ago

Understandable concern, but I felt compelled to comment when you said that the FAANG stocks are under-owned by most active managers… so they are “over-owned” by who? Not the passive, index owners, but by other active managers. Still has to be a zero-sum net ownership.

Even if they are so big so that their earnings growth and valuation premiums subside, I think they will likely be solid return “ballast” for the overall market. Slower than expected growth might still provide modest positive returns for the them. The unidentifiable other big winners within the market will propel the averages. Underweight the biggest most successful companies at your risk!

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