Charley Ellis was on the Capital Allocators podcast with Ted Seides last week. Charley has been in the investment management business since the early 1960s. Today he is one of the most vocal proponents of index funds as the most sensible investment for most people.
I write often about why index investing makes sense, and why it is challenging for active investment management to generate consistent outperformance. While that has always been true, there are some good arguments for why it is harder now than ever for active managers.
On the podcast, Charley offers some reminders about how the world and the stock market have changed since the 1960s.
According to Charley 10% of trading, at most, was done by institutions, and 90% was done by individuals. Most of those individuals were, as Charley describes, “nice people” who were investing their savings in stocks without doing much, if any, research. In other words, there were lots of easy targets for an active manager to exploit.
In the past, it was possible for an analyst to set up a private meeting with a company’s management in order to get an information edge.
Charley estimates that there were less than 5,000 people in the active investment management business.
Securities firms had 10 to 12 analysts who were only searching for interesting investments for the firm’s partners, and were not publishing their research.
About 3 million shares traded each day.
Charley says that 99% of all trading today is done by computers. Most investors involved are highly skilled and have instant access to information. In other words, there is no easy target left to exploit.
Today, under Regulation FD, the SEC requires that any material information that is disclosed must be disclosed publicly. Under Reg. FD It is not possible, legally, to get a competitive information advantage.
Charley estimates that there are over 1,000,000 people in the active investment management business. There are around 154,000 CFA Charterholders in the world today.
Securities firms today have hundreds of analysts with diverse expertise in every major financial hub constantly publishing their research.
More than 5 billion shares trade each day.
The Paradox of Skill
Piling an increasing number of skilled professionals into the investment management business might seem like it would benefit investors, unfortunately it does not. Michael Mauboussin and Dan Callahan explained the paradox of skill in a 2013 Credit Suisse white paper:
In investing, as in many other activities, the skill of investors is improving on an absolute basis but shrinking on a relative basis. As a consequence, the variance of excess returns has declined over time and luck has become more important than ever. Still, differential skill continues to exist. This process is called the paradox of skill.
Put simply, if equally skilled and informed investors are competing with each other, the winner will be defined by luck rather than skill. It is not absolute skill that matters, but relative skill.
If there has ever been a time for active money management to flourish, that time is not now. This shows up consistently in the results of active fund managers; the vast majority of them underperform the index over any given time period.
There is little question that simple low-cost index funds are the most sensible investment for most people. Paradoxically, the case for index funds grows stronger as the investment management industry gets more skilled.