Tue. Jun 6th, 2023

Charles Ellis is an investing pioneer, having founded financial-consulting firm Greenwich Associates in 1972 and written an early defense of index investing, “Winning the Loser’s Game,” whose eighth edition was published recently.

He also served as chairman of the Yale Investment Committee.

In this interview, he discusses why passive investing is a better bet than ever and shares some thoughts on the legacy of his recently deceased friend, the great investor David Swensen of Yale University. It has been edited for length and clarity.

Howard Gold: “Winning the Loser’s Game” was first published in 1985. I interviewed Nobel Prize winner Eugene Fama, whose paper that established the efficient market theory had been published maybe 10 or 15 years before that. The late John Bogle was just getting under way at Vanguard. Thirty-six years later, has passive investing finally won the battle?

Charles Ellis: It certainly is winning the battle. Every investor should be an active investor in the sense of actively figuring out who they are, what their circumstances are, what they’re trying to accomplish, what they’re trying to avoid, what will work for them [as a] long-term investment even as markets go up and down.

Gold: What specifically has changed? You mentioned in your book that institutions dominate the market even more. I think you had a figure they represent 90% of trading volume, but that’s really a huge change from, say, 40 to 50 years ago, when the model was buy good individual stocks that pay dividends and that’s how you would get rich, right?

Ellis: If you go back, the amount of trading done by individual investors was roughly 90% of all the market activity. Those individual investors bought or sold for reasons completely outside of the market itself. I got a bonus, I made an investment. My son’s going off to college, so I took money out. Then, half of the transactions by individuals were in AT&T common stock. [Institutions also tended] to be cautious, conservative and careful. And that means you [bought from] a list of maybe 30 or 40 major blue-chip stocks [and held them] for the long, long, long term.

Gold: And now it’s the complete opposite — institutions dominate the market and engage in rapid-fire trading. In the book, you said that over 15-year periods, some 90% of active funds underperform the indexes. And as Gene Fama told me, the key is predictability. You don’t know at the beginning of those 15 years which 10% of funds are going to outperform and which are going to underperform, right?

“You’d probably be in the top half or one-third of the top quartile, but you’re guaranteed to be in the top quartile if you use indexing.”

Ellis: That is terribly true, [but] there is a nice, easy solution to the problem. If you ask most investors, how would you like to be able to describe your investment [performance] 10 years, 20 years, 30 years from now, most people would say, “Honestly, if I could be top quartile, I would be thrilled.”

You can guarantee you will be in the top quartile. You’d probably be in the top half or one-third of the top quartile, but you’re guaranteed to be in the top quartile if you use indexing.

Gold: So, by buying what critics call “mediocre” index funds, you’re guaranteed to be in the top 25% almost by definition. Why don’t fund companies go all in for indexing? Are they run for their shareholders and employees, rather than for investors? Are they more concerned about growing assets and paying employees well enough to keep them than they are about market-beating returns or keeping fees down?

Ellis: I think that’s true. If you’re running a very large organization, you’re almost guaranteed to have as the senior executives managers with a commercial instinct rather than professionals with purpose, predilection or enthusiasm for investment results. And it’s very difficult for the commercial interest to appreciate what it takes to be skillful in the long run as a professional, and vice versa.

Gold: OK. So again, you think that average people, should really not invest in active funds and should exclusively put their portfolios in index funds or exchange traded funds (ETFs)?

Ellis: Well, if they want to do really, really well, index funds are a sure way of doing that. And if you do risk-adjusted return, you’re in the top half of the top quartile, then you are guaranteed to be a winner. That ain’t bad.

“Every major trend that I know of has worked to make it harder and harder for active managers to do better than the index.”

Gold: What has changed in the past, say, 20 years to make it harder for active managers to beat the indexes?

Ellis: Every major trend that I know of has worked to make it harder and harder for active managers to do better than the index. Regulation FD for fair disclosure [adopted by the SEC in 2000] says any publicly listed company must make a diligent effort to get the same information to everybody. The absolutely wonderful Bloomberg terminals are everywhere and they give you any information you want, any way you want it, any time you want it.

If you go back 50, 60 years ago, a major securities firm might have had 15 analysts, but they would be mostly focused on finding “interesting” stocks for the partners, not for customers. Today, we have [hundreds of] analysts at every major securities firm. They’re all out there competing with each other for getting accurate, useful information into the hands of investors. But the consequence of the devices, computers and technology is that everybody knows everything all at the same time, everywhere. When you get that kind of talent back and forth, with that kind of information, and the intensity of competition, it doesn’t leave much room for nice people like you or me.

Gold: Or nice people like MarketWatch readers who are trying to invest for retirement or for their kids’ college education, or whatever. You talked about whole-picture investing in your book, and we all have careers, we all have a way of estimating the value of that. You say that’s more important than trying to beat the market, that it will contribute much more to your financial well-being over time. Could you talk about that?

Ellis: Almost everyone makes the simple mistake, and that is to look at the investment portfolio as though it was the total picture. And it’s not. For most people, yes, they’ve got a securities portfolio, but they also have a home, there’s value in that home, and it doesn’t go up and down with the stock market. So you’ve got a diversification and a stabilizer at the same time. If you look at Social Security, it is a pretty darn valuable asset if you do the calculation to its present value, and it does not go up and down with the stock market.

Gold: It’s the best annuity you can get, right?

Ellis: From the best credit that we know of in the world.

The other thing is, what’s your earning power or the value of your intellectual property? Most people, looking at their earnings, would say, “Gee, I would love to earn more.” However, they’re all earning quite nicely, and would be able to calculate what would be the present value of that future earnings. What do I need to pay you, so that you’ll turn over your paycheck to me for the rest of your career?

If you look at all those different component parts, most of us have way too much in stable assets, which is what bonds are supposed to do, which is why in the present circumstances, where the expected inflation is higher than the rate of return on the bond, it’s really hard to justify being a bond investor today.

Should a pre-retiree own bonds? “I’m 83 1/2, and I don’t own any bonds. Zero.”

Gold: For someone who is, say, 60, and is going to retire within 10 years, should they put zero in bonds? Should they put that money instead into cash, or money market funds?

Ellis: I’ll give you an example. I’m 83 1/2, and I don’t own any bonds. Zero.

Gold: Well, you’re actually better off than a lot of people are, right?

Ellis: Yes, I’ve had a very financially happy life. I also happen to be involved in a line of work where people don’t care so much what your age is. I’m at a point where I’m able to earn my living to cover the family expenses. But that also means that I don’t have to be anxious about meeting the sudden demand for money.

And the reason for owning fixed income is usually anxiety about the market going up and down, but if you take the total portfolio, which we were just discussing, the market is only a small fraction of all your assets. All the other assets don’t go up and down when the market does.

“Questions about cryptocurrencies, GameStop, Robinhood, all of that, that’s really interesting, but it’s a little bit like a dinner party, a cocktail party, for people in their early 20s.”

Gold: Let’s talk about some recent developments in the market: GameStop
the so-called “meme” stocks, Robinhood, Reddit message boards, SPACs, NFTs, crypto. We’re seeing a lot of things that look very frothy and euphoric. Do you agree that those are signs of that? And if so, how does that affect whole- picture investing, the positioning in your portfolio when you’re a long-term investor?

Ellis: I think questions about cryptocurrencies, GameStop, Robinhood, all of that, that’s really interesting, but it’s a little bit like a dinner party, a cocktail party, for people in their early 20s. I’m not going to get involved with that kind of stuff because I don’t understand what they’re doing. And I know I don’t know. I actually don’t much care, although I hope nobody gets hurt very badly.

Gold: Is this a lesson that every generation has to learn? Do people always have to learn the hard way?

Ellis: Everybody’s on their own to do that kind of learning.

Gold: You were the chairman of the Yale Investment Committee.

Ellis: I was chair of the committee for quite a long time. I served on the committee 17 years by the time I was chair, but I’ve been off that committee for 15 years.

Gold: OK, because I wanted to talk a little bit about David Swensen, who passed away recently because of cancer. People have tried to apply his innovations in investment management to individual investors, although Swensen himself discouraged individuals from investing that way because of the unique circumstances of institutional investing. Can you speak to his legacy?

Ellis: David Swensen was the most extraordinarily wonderful person anybody in investment management has ever seen or talked to. He wrote the best book that’s ever been written about institutional investing (“Pioneering Portfolio Management”). He taught people how to think about institutional investing in a new and very effective way. He also was a wonderful friend, a person that you couldn’t help but admire and enjoy any time you spent with him.

He was entirely focused on Yale and Yale’s purpose. Very few people could hope to replicate that kind of character and integrity that David had, but they can learn the lesson of concentrating on the main game, your principal mission and responsibility as an investor. Be sure you understand your key characteristics, develop a rigorous plan for implementation and then stick with the plan.  

It’s important for us to recognize how extraordinary he was. He was the first person to do an [interest rate swap] between IBM and the World Bank, a floating rate note to a fixed rate. Everybody in the industry knew that couldn’t be done because it never had been done.

And David said, “No, I think it can be done, and I would like to see if I can work it up. I’ve got a couple of different possibilities in mind.” Boom. We now do more in derivatives trading than we do in the cash market. That kind of originality.

Gold: He could have started a hedge fund and become a multi-billionaire. He did very well, but he chose to stay at Yale. His investing helped a lot of underprivileged kids get a chance to go to Yale. Any last thoughts?

Ellis: I do believe that there are certain fundamentals which people of all degrees of experience should be paying close attention to. Number one is who are you as an investor? What makes you unique? Then relate your investment portfolio to that unique set of circumstances that make you such a wonderful person. If you don’t take a long-term view, you’re almost guaranteed to be in trouble. I do think it’s kind of fun that you can do the easiest kind of investing the world has ever seen — indexing — and guaranteed to put you in the top quartile.

Gold: Does it help to have an adviser?

Ellis: I think an adviser can be very, very helpful. I would favor a one-time fee-paid adviser. The markets change all the time, but we don’t change very much, and so you don’t need somebody holding hands, all day, every day. But I would recommend [working with an expert adviser] to anybody who was trying to do a good job with investing, and not make stupid mistakes. All of us make mistakes, but we don’t have to make so many mistakes.

Howard Gold is a MarketWatch columnist who regularly does Q&As with leading investors and thinkers.