...it's that they have no competitive advantage.
A MONEYWEB ARTICLE BY PATRICK CAIRNS, FOLLOWING THE FIRESIDE CHAT WITH DR CHARLES ELLIS
When Charles Ellis wrote his now famous paper The Loser’s Game in 1975, he was in the midst of watching a huge shift taking place in the world of investment management. He was seeing the erosion of the competitive advantages that had set the top-performing active managers apart.
Speaking at an event organised by Satrix in Cape Town, Ellis recalled how the Rockefeller family office in which he had worked in the early 1960s was one of the first to have direct access to real-time stock prices through a newly patented desktop machine. Before that, the only way to get current prices was to call a broker.
In-depth research was also rare. Only a few companies were starting to produce the kind of comprehensive analyst reports that are commonplace today.
In fact, investment management wasn’t even much of a recognised profession. Harvard Business School, where Ellis had studied, offered no investment courses.
This was the environment in which a new breed of active managers found that they could exploit the inefficiencies in the system to generate meaningful outperformance.
A RETAIL MARKET
“In the 1960s, only 9% or 10% of trading was done by institutions,” Ellis points out. “All the rest was done by individuals who bought or sold once every year or two and they didn’t know much of anything because no one would provide research that they could have access to. They might have read Forbes, or their broker might have known something, but more likely both broker and investor knew nothing and only acted based on conventional wisdom.”
This created incredible opportunities for active managers who were able to act more quickly, and on information that not everybody had.
“The secret sauce in the 1960s was to get ahead of the others by talking to companies, and getting a feeling for what it was that made them distinguished,” says Ellis. “The second advantage was time. You had something like six months to a year to invest on the basis of that knowledge before the market would catch up.”
This allowed the best active managers to outperform significantly. However, as more and more managers began to work this out, their competitive advantages became smaller and smaller.
Information became more widely available, and computers were able to deliver it faster and more accurately. The number of firms engaged in managing money on the stock market and the assets they managed also increased exponentially. So did the amount of trading taking place.
While in the 1960s around three million shares traded daily on Wall Street, that number has grown to around four billion today.
“There has been a huge transformation in the volume of trading,” says Ellis. “But much more importantly, an unbelievable transition in the fraction of that trading done by expert professionals compared to willing losers.”
Around 99% of trading on the New York stock exchange is now conducted by professionals, who are, as Ellis points out, “all equally informed, all equally armed, all equally equipped”.
In other words, any professional wanting to buy or shell shares is buying them from or selling them to someone who has all the same advantages they do. That results in a market where it is incredibly difficult for anybody to add value after the costs they incur.
FEES BECOME A KEY DIFFERENTIATOR
“If the average fee for a retail fund is around 100 basis points, and average cost of operations is another 100 basis points, I have to take those 200 basis points and put them in comparison to the returns,” Ellis explains. “If the market is producing 7%, I have to beat it by two-sevenths just to cover those expenses charged to your account.
“That’s a pretty tough achievement,” he says. “I have to be better than my smart competition most of the time, year after year by that much. You’re talking about 25% to 30% better than all those smart people who are equal in computing power, equal in information, equal in intensity of work, equally bright.”
This is why fees have become such a key differentiator. The lower their fees, the lower the hurdle an active manager has to overcome to outperform.
“It’s not that all active managers have failed,” Ellis explains. “It’s that there is no way other than low fees to identify in advance the active managers that are going to come out ahead of the market or market segment they are trying to beat. It’s a slightly different, more horrifying reality.”
It is horrifying not because active managers are so bad at what they do, but precisely the opposite.
“If you want to find a really good active manager, that is easy,” says Ellis. “There are lots of them who are really smart, very articulate, sincere in their convictions, and proud of the talented people that they have working in their business. The only problem is it’s easy because there are so many of them, and that makes it hard for any of them to be visibly, noticeably different.”
This is why Ellis has become a proponent of index investing:
“If you get to the point where smart, skilled, informed professionals are dominating the market, indexing is the only sensible alternative, because the cost of competing exceeds the value that you can add.”
POSTED : 23 OCTOBER 2018