Writing in Saturday’s WSJ column “The Intelligent Investor,” Jason Zweig reviews a recent article by the “dean of the investment-management industry” Charles Ellis, who claims in the July/August issue of the Financial Analysts Journal that the “active vs. passive investment debate” is largely over. After their high trading fees and expenses, “active managers are no longer able to earn their keep,” and therefore most investors will get higher returns and pay lower fees with index funds. Ellis expects that the triumph of index investing over active fund management is generating a “wave of creative destruction” that will put many portfolio managers out of business. Here’s an excerpt of Jason Zweig’s article “The Decline and Fall of Fund Managers“:
Active fund management is outmoded, and a lot of stock pickers are going to have to find something else to do for a living. The debate about whether you should hire an “active” fund manager who tries to beat the market by buying the best stocks and avoiding the worst—or a “passive” index fund that simply matches the market by holding all the stocks—is over. So says Charles Ellis, widely regarded as the dean of the investment-management industry.
Stock picking “has seen its day,” he told me this past week, as assets at Vanguard Group, the giant manager of market-tracking index funds, approached $3 trillion for the first time. “With rare exceptions, active management is no longer able to earn its keep.” If he is right, hordes of portfolio managers will eventually be thrown out of work—and financial advice could end up cheaper, better and more plentiful than ever before.
In an article in the latest issue of the well-respected Financial Analysts Journal (see below), Mr. Ellis argues that fund managers equipped with sophisticated analytical tools, electronic trading and instantaneous access to news are engaged in an arms race resulting in a kind of mutually assured destruction of out-performance. The faster and smarter each manager becomes, the more efficient the market gets and the harder it is for any manager to beat it. As a result, he writes, “the money game of out-performance after fees is, for clients, no longer a game worth playing.”
No one gave a hoot about fees in the 1980s and 1990s, when 2% in fund expenses barely made a dent in the 18% average annual returns of U.S. stocks. But since the beginning of 2000, stocks have returned an average of just 4% annually. A 1% fee is a quarter of that return. Fees will come down because they have to.
And that, Mr. Ellis warns, will lead to “a wave of creative destruction” comparable to the changes that swept through the steel industry decades ago. To Mr. Ellis, the future for many portfolio managers is clear: “Lots of them are going to have to go find something else to do, because the line of work they originally trained for will be fading away.”
Here’s the abstract of Charles Ellis’s article “The Rise and Fall of Performance Investing” from the July/August issue of the Financial Analysts Journal:
Performance investing has enjoyed a remarkably long life cycle, but the costs of active investment are so high and the incremental returns so low that, for clients, the money game is no longer a game worth playing. Investors—both institutions and individuals—are increasingly shifting toward indexing. As acceptance of indexing grows, clients and managers have an opportunity to stop focusing on price discovery (which has made our markets so efficient) and refocus on values discovery, whereby investment professionals can help investors achieve good performance by structuring an appropriate, long-term investment program and staying with it.
Here’s part of Ellis’s conclusion:
The ironic triumph of active performance investors, who are so capable of price discovery, is that they have reduced the opportunity to achieve superior price discovery so much that the money game of out-performance after fees is, for clients, no longer a game worth playing. The obvious central question for our profession—for each individual and each firm in active investment management—is, When will we recognize and accept that our collective skills at price discovery have increased so much that most of us can no longer expect to outperform the expert consensus by enough to cover costs and management fees and offer good risk-adjusted value to our clients? Another central question is, When will our clients decide that continuing to take all the risks and pay all the costs of striving to beat the market with so little success is no longer a good deal for them? These questions are crucial because to continue selling our services after passing that tipping point would clearly raise the kind of ethical questions that separate a proud profession from a crass commercial business.
MP: My advice is to build your investment portfolio using a variety of index funds — it’s not settling for average, it’s just refusing to believe in the miracles and magic of active management.