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.

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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