Author Charles Ellis contends that structural changes in the US market have eliminated the prospect of outperforming average market returns, after fees, through active management. The causes include the rise in institutional and high-speed machine trading and changes in regulation. Active management may still pay off in low-efficiency markets, such as high-yield bonds and emerging market debt. The book does not address findings that the most active stock pickers who take large but diversified positions unlike the index weightings beat their benchmarks.
Charles Ellis began his illustrious career in the financial industry in 1963, around the time Paul Samuelson started circulating Louis Bachelier’s largely forgotten findings on market efficiency to his fellow economists. In 1965, Eugene Fama made the case for a random walk in securities prices in his doctoral dissertation.1 That era is the base period for the argument Ellis presents in The Index Revolution: Why You Should Join It Now. In essence, he contends that although theory already supported the superiority of passive investing half a century ago, subsequent structural changes in the market have eliminated, in practice, the prospect of outperforming the averages through active management.
“Today’s stock markets are almost totally different from the markets of 50 years ago,” Ellis writes. Among the key changes he lists is a shift from individual, amateur investors accounting for 90% of NYSE volume to institutional and high-speed machine trading accounting for 98%. These organizations respond swiftly to expert research distributed instantaneously via the internet to hundreds of thousands of analysts and portfolio managers. Over 320,000 Bloomberg terminals now crank out massive market and economic data nearly 24 hours a day. Furthermore, the US SEC’s Regulation FD (Fair Disclosure) has been a game changer by eliminating the opportunity to obtain corporate information ahead of competitors, which Ellis says was “central to successful active investing” prior to 2000.
Circa 1966, according to Ellis, expecting a skilled investment team to beat the averages was realistic. No longer, he contends. Or rather, he says it is now “virtually impossible for all but a very few” to achieve that goal. He mentions in a footnote that Vanguard, Capital Group, and T. Rowe Price appear to be exceptions to the general rule that the handful of firms that outperform the market after fees, costs, and taxes are small, difficult to identify, and likely to be replaced by others in the future. Ellis also notes that analysis and issue selection apparently pay off in high-yield bonds and emerging market debt, among other categories characterized by low efficiency. Still, he maintains, efforts to beat low-cost indexing are by and large futile and efforts to improve on indexing with smart beta strategies are doomed to failure. At the same time, though, Ellis acknowledges that Dimensional Fund Advisors and AQR have “done well at factor-based investing for many years.”
Absent from Ellis’s otherwise comprehensive coverage of the topic is a discussion of the “active share” concept introduced by K.J. Martijn Cremers and Antti Petajisto. It should surprise no one that, in aggregate, a sample of mutual funds that includes many closet indexers produces no outperformance net of fees and expenses. Cremers and Petajisto, however, found that the most active stock pickers who take large but diversified positions unlike the index weightings beat their benchmarks by more than a full percentage point after fees and expenses.2Readers should draw no conclusions about the market efficiency debate before examining the challenges to—and defense of—these findings, as recorded in the pages of the Financial Analysts Journal.3
In addition to laying out the merits of passive investing, Ellis offers a wealth of valuable insights into the evolution of the investment management industry and its sometimes misleading practices. For example, he explains that when a consultant retained by institutional investors to help select managers drops a manager from its recommended list, it usually deletes all data on that manager from its records. Conversely, when a consultant adds a new manager, it retroactively adds the manager’s favorable results from previous years. The resulting chart overstates the benefits an investor would have reaped by following the consultant’s past recommendations.
Readers of The Index Revolution will benefit from the author’s erudition, honed in obtaining a PhD in finance, as well as his decades of experience as a practitioner. Further investigation was needed, however, on one minor item. Ellis writes that Albert Einstein is said to have defined insanity as doing the same thing over and over again while hoping for a different outcome. There is, in fact, no reliable evidence that Einstein ever said any such thing.4
Setting aside this quibble,The Index Revolution belongs on the reading list of anyone grappling with the choice between active management and passive investing. Ellis appropriately emphasizes that the quest for increasingly elusive alpha should not divert attention from more important issues of investment policy. This warning is particularly true for investors who are pursuing excess risk-adjusted returns by methods that, as detailed in this book, are almost guaranteed to backfire.
—M.S.F.