Planner or Prognosticator?September 10, 2014
In an article in the recent issue of the Financial Analysts Journal, Charles D Ellis explains that the growing acceptance of passive investing will change the structure of the investment industry as we know it.1 [Please note that the article is free for members of the CFA Institute and $15 for nonmembers.] With a lackluster track record, slowing asset growth, and pressure on fees, active managers will face significant headwinds in the future.
Ellis is a long-time advocate of passive investing who has taught and served on the board of both the Harvard Business School and Yale University. He is best known for his 1975 book, “Winning the Loser’s Game,” where he stated, “The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.”
In this article, Ellis talks about the changes in the industry over time, citing the global commoditization of insight and information and increasingly sophisticated competition. “The increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them — particularly after covering costs and fees.”
Beyond the greater levels of information availability and competition, Ellis remarks that the investor’s challenge is exceedingly problematic. “Forecasting the future of any variable is difficult, forecasting the interacting futures of many changing variables is more difficult, and estimating how other expert investors will interpret such complex changes is extraordinarily difficult.”
While knowing what will happen next is nearly impossible, Ellis argues that when it comes to active management, the recent history may not be very useful either. “Although firms continue to advertise performance rankings and investors continue to rely on them when selecting managers, rankings have virtually zero predictive power.”
Ellis tallies the track record of active funds from 1997 through 2011. His findings indicate that being able to select an active fund which outperformed its benchmark is extremely problematic, with an average of just 20.5% of funds outperforming their benchmark over the 15-year period.
Even in the face of this and other evidence such as the Standard & Poor’s Active vs Passive studies2, active management retains nearly 75% of the total mutual fund landscape. Yet, while the pool remains much larger, the flow has shifted dramatically towards passive or market-oriented funds. In 2013, passive funds brought in 66% of net inflows, showing that investors are catching on to the ‘losing game’ of predicting stocks.
Ellis lays out an interesting question: “If your index manager reliably delivered the full market return with no more than market risk for a fee of just 5 bps, would you be willing to switch to active performance managers who charge exponentially more and produce unpredictable varying results, falling short of their chosen benchmarks nearly twice as often as they outperform — and when they fall short, losing 50% more than they gain when they outperform?”
Ellis views the two traditional roles of money managers as two different hands clapping together, one hand based on the skills of price discovery (finding undervalued companies) and the other hand based on values discovery (determining each client’s realistic objectives). Where advisors in previous decades might have been able to hang their hats on the promise of pioneering price discovery, advisors today should focus on values discovery which he says will offer more opportunities for real, long-term success to both the profession and the client.
What do you think? Do you believe there is a more promising future being the planner or the prognosticator?
Implementing a passive strategy cannot guarantee a gain or protect against a loss.
1“The Rise and Fall of Performance Investing,” Charles D. Ellis, CFA, The Financial Analysts Journal, Volume 70 Number 4
2Standard & Poors Index versus Active (SPIVA) US Year End 2013 Report
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