I just finished reading The Index Revolution by Charles D. Ellis. Ellis is a Yale and Harvard grad who founded a well-known investment consulting and research firm called Greenwich Associates. This book appears to be his swan song, with brief descriptions of his career, relationships, and family, almost like a chat with a grandfather who wants to reflect on his career and isn’t sure he’ll get another chance. [I hope that comes across respectfully. I wish my grandfather had any investment knowledge to pass on]. I don’t write book reviews, so instead I want to relay what I think are some key points of the book:

  • Mutual fund ratings are not very useful. According to this book, Morningstar’s 1-star rated funds have outperformed its 5-star funds. Morningstar has found that the only variable that is predictive of active mutual fund returns is their cost, and the cheaper the better. Perhaps the one exception to this is that the worst decile of performance tends to stay poor, likely because of high fees or incompetency.
  • One key in investment selection is to not look at an active mutual fund that is performing well and has a high rating and expect that to continue. Most active mutual funds trail their index even after the first year, and it only gets worse from there. Mutual funds that have performed well tend to revert to the mean by performing poorly. Most fired mutual fund managers end up outperforming their replacements.
  • Ellis goes into reasonable detail about why index investing is successful. Part of his explanation is that as investment management has become more financially lucrative, more and more research, brain power and computing power have gone into it. I joke with my clients that it is hard to compete with all the Ivy League MBAs running these mutual funds, and that’s true. They have access to company executives, proprietary software, PhD’s in almost every field and years of rigorous training. Yet, as mentioned in the prior bullet point, they still fail to beat the market. Further, they are involved in almost 99% of trades at the present time, so every time some Harvard MBA thinks he is brilliant by buying a certain stock, there is a Yale PhD on the other side of the trade who thinks she is fleecing the buyer at that price.
  • Ellis also rips into the problems facing the active mutual fund industry. Their sole job, the sole reason they supposedly provide value, and the basis for their billions of dollars of fees per year is to beat the market, yet they overwhelmingly fail. To justify their jobs, they essentially lie about their performance by closing bad funds, marketing the funds that performed well recently, hiring managers who had a good year with another firm and then claiming that performance as their own, etc. Meanwhile, they continually increase their fees, engage in mergers and acquisitions to increase their profits, move away from actually counseling their clients, create new products that are not in investors’ best interest, and flout the law (I added the last two), all in an effort to enrich themselves at the expense of the people they are supposed to be helping.

None of this is groundbreaking, but it is succinctly explained in the book. In addition to the important points described above, here are a couple of new perspectives that I gained:

  • We should start thinking of investment fees as a percentage of returns, not a percentage of assets. The mutual fund company is not taking on the same risks as the investor, and the mutual fund company did not contribute any money to the investor’s account. A 1% expense ratio on $100,000 invested is $1,000. If the rate of return that year was 5%, then the mutual fund company’s fee was 20% of profits. If the rate of return was negative, then the mutual fund company still gets paid yet shared in none of the investor’s losses. This a great way of looking at investing fees and why they should be minimized to the greatest extent possible.
  • If I understood Ellis correctly, he stated that the larger funds may have as much as a 2% per year drag on their performance as a result of their purchases driving up the price and their sales driving down the price as they go through the process of buying or selling a large number of shares over time. This drag does not impact index funds as greatly because they trade much less often.

I’m still on the fence of the active versus passive debate. As a Warren Buffett admirer, I’ve read his discussion of “Graham and Doddsville” where a certain breed of value investors can consistently outperform index investing through study, discipline and execution. I’ve also written about various factor and tactical asset allocation methods that blend active and passive strategies. Such strategies may be able to deliver superior risk and cost-adjusted returns and perhaps reduce the downside risk of a portfolio without significant sacrifices. There is a continum of risk between the different strategies, with passive index investing being on the lower side of risk, on the lower side of expenses and on the middle-to-higher side of performance, although each of those positions is debatable. This book affirmed my belief that passive index investing should be the preferred investment method for most people in most circumstances. Under almost no circumstance do I recommend active mutual funds, for the reasons that Ellis describes in his book.

Every investor and adviser needs to have a firm grasp of the pros and cons of passive and active investing. This book provides a great discussion of the pros of passive investing and the cons of active investing without being very technical. The statistics provided are fairly convincing, but I would have preferred more time devoted to the more technical aspects of passive investing.  I also believe Ellis wasted an opportunity to provide more than a cursory discussion of recommended portfolio models for index investors and whether equal weight or other passive fund compositions are preferable to market cap weighted funds. That said, I believe this book should be part of everyone’s repertoire and on their minds when thinking about their investment philosophy.

-Richard

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