After a wonderful education at Exeter, Yale, Harvard and NYU and earning an early CFA, entered the investment field in 1963 as active investing was becoming increasingly important. Organized and led Greenwich Associates, the global firm serving financial service organizations for 30 years and observed many major changes that made active investing harder and harder and became a leading advocate of indexing. Along the way, taught advanced investment courses at Harvard and Yale and the CFA Institute in-service course at Princeton. Wrote over 100 articles and 20 books, mostly on investing and investment companies.
When it comes to the world of investing, there are many options available to consumers. The range of financial products available can be overwhelming and confusing. Additionally, investing is not only about the rate of return but also about what you are investing for and why. To help us unpack this complicated subject is Charles Ellis, a highly respected investment consultant and founder of Greenwich Associates, a strategy firm focused on financial institutions. He is also a famous author and has written several books on the topic of finance and investment, such as Winning the Loser's Game which provides readers with insights into making the best financial decisions in an increasingly unpredictable market. In our conversation, we discuss why indexing is the better investment option, how the investment space has changed over time, tailoring your investment decisions to suit your needs and desires, and why looking at the bigger financial picture is essential. We also delve into why investors can be their own worst enemies, what advisors and investors should avoid, the theme of his book Inside Vanguard, various investment strategies, and much more. Tune in and hear insights on indexing, wise investing, and how to win the ultimate game from industry legend Charles Ellis!
Key Points From This Episode:
Charles explains what he means by ‘a loser's game’ and provides examples. (0:03:51)
How the perception of active management has changed since publishing Winning the Loser's Game. (0:08:00)
He unpacks how the market and market competition has changed since 1975. (0:10:33)
Whether the sentiment towards active management has become too negative. (0:17:24)
Discover why Charles thinks indexing is the best and preferred investment option. (0:19:22)
His opinion on low-cost systematic strategies that seek higher expected returns in the market by owning riskier stocks. (0:24:55)
Why investors and advisors should avoid trying to time or beat the market. (0:27:19)
The value and importance of a well-defined investment policy statement. (0:33:34)
Find out how investors can protect themselves from themselves. (0:34:58)
An underappreciated approach that investors can take to be more successful. (0:36:26)
Hear whether fee differentials between index and active strategies are understood well. (0:37:17)
Charles shares how his mindset has changed over the course of his career. (0:41:47)
Find out if institutions and endowments respect low-cost index investing. (0:42:42)
What he thinks about bringing exotic asset classes to retail investors. (0:44:45)
Reasons why investment management should be considered a full-time profession. (0:46:50)
The biggest opportunities he sees in future for investment management. (0:49:20)
Hear about the difference between price discovery and value discovery. (0:50:09)
Discover why Vanguard has been so successful as a company. (0:53:27)
The theme of his book, Inside Vanguard, and if it relates to other businesses. (0:58:17)
Lessons he has learned regarding personal motivation and productivity. (1:00:28)
Charles tells us his definition of success. (1:03:35)
An outtake from the episode: the role of luck. (1:05:21)
Read The Transcript:
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from two Canadians. We are hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.
Cameron Passmore: Welcome to Episode 244. This week, we welcome a spectacular guest and a super nice guy, the well-known Charles Ellis. A very well-known and respected investment consultant, and author. He has been one of the longest and most active proponents of index investing, and articulate on that as well, and is the author of perhaps, his most famous book, Winning the Loser’s Game. He's also the founder of Greenwich Associates, which is a strategy firm focused on financial institutions.
I was thinking about his book. Other than Larry Swedroe, which is probably the author I’ve read the most, I think Charley is next. I’ve read for sure, four of his books, which I loved every one of them. They're all very different because he writes about the investment industry, as well as about quality businesses. Love his material. Great conversation, Ben.
Ben Felix: Yeah, great conversation. Winning the Loser’s Game belongs on the shelf of classic investing books that everybody should read as an investor. In going through it, again, I read it previously, but in going through it again, recently to prepare for this conversation, I was struck by, it's not a super long discussion in the book, but there's a discussion of the difference between price discovery, which is efficient capital markets and security pricing, and value discovery, which is the idea of discovering for you as an individual, or for you as an institution, what you're really investing for. What is your motivation? What is the ultimate outcome that you want? Not the rate of return, but what are you really investing for?
He wrote this book a long time ago, in its first edition. I found that discussion, given that context of how long ago this was written, to be profound, because this is something that we've just recently tried to start thinking about and focusing on is that idea of helping people live good lives, as opposed to just earn a higher return. This is something that Charley's been thinking about for a very long time.
Cameron Passmore: Very long time. Charley's been on the faculty of both Harvard and Yale, and for nine years, he was the chair of Yale's Investment Committee, alongside legendary David Swensen. Can you imagine? It's incredible.
Ben Felix: That's incredible.
Cameron Passmore: He's also the author that recently released and excellent book, Inside Vanguard: Leadership Secrets from the Company that Continues to Rewrite the Rules of the Investment Business. Also, the book Figuring It Out: Sixty Years of Answering Investors’ Most Important Questions. I got introduced to Charlie by Robin Wigglesworth. Thanks to Robin for the kind intro.
When I reached out to Charley, he suggested that I read his recently released book, What It Takes: Seven Secrets of Success from the World's Greatest Professional Firms. I must say, for anyone who's in that environment, it is an excellent book, and it just shows his determination to learn and to write is unreal. He's 85-years-old, and he is just as driven, I think, as ever. What can you say? Charley is a legend. This was an incredible conversation. He's a great communicator. Make sure you stick around to the end. We have an outtake after we thanked him, when we talked about luck. Stay tuned to the very end. Anything to add, Ben?
Ben Felix: No. That’s great. Let's go ahead to the episode.
Cameron Passmore: All right. Here's our conversation with Charley Ellis.
***
Charley Ellis, it's a real privilege to welcome you to the Rational Reminder Podcast.
Delighted to be with you. I hope it's fun, from your point of view and for your participants.
Well, Ben and I have been reading your material for years and this is a real thrill for us. Let's kick it off. Your most well-known book is Winning the Loser’s Game. What is a loser's game?
A loser’s game is any competitive activity, where the outcome is not controlled by the winner, but it's actually controlled by the loser. Golf is a good example. People that are really good at golf will shoot less than par, by two or three strokes on a regular basis. A lot of other people are proud to be able to shoot 90. There are some people who've never broken a 100. Well, the difference between the two groups is the mistakes of the people who've never broken a 100 and make all the time. They don't swing quite correctly. They don't keep their eye on the ball quite correctly. They don't follow through quite correctly, and they hit the ball sometimes in the damnedest places.
Another loser's game is tennis. I got onto this, it is a very lucky break by reading a book about how you can play your best tennis all the time by a wonderful, by a brilliant American leader, Simon Ramo, who probably should have been most famous because of what he did for NASA. He was at TRW, Thompson Ramo Wooldridge. Really designed most of the efforts that went into NASA during the critical years. He also happened to be a gifted musician, and he and three members of the Los Angeles Symphony Orchestra played in public, quartets on a regular basis. He happened to be a really good athlete. His favourite game was tennis. He wrote this little book, How to Play Your Best Tennis All the Time. It's a marvellous example of a rational person approaching a game, like tennis. He's explained, if you hit the ball back on a regular basis, let the other person have every opportunity to make mistakes.
If you look at your game and my game, or at least my game, how many times do you win a stroke, instead of hitting it at the net, hitting it out of bounds, laying it up so easily for the other person hit it back, that you've essentially forced yourself into a loss? If you could cut back on the number of mistakes and let the other guy increased the number of mistakes he made, you'll come out the winner of a loser's game. Then if you think just for a minute, that's what investing is all about. Most of the activity that most of us spend our time engaged in, in investing actually doesn't help. It actually does harm.
Our long-term results are impoverished by the mistakes that we've made along the way. Not doing some things and actually doing some other things. Trading too much. Trying to time the market, things of that nature, do have operating costs, then those costs accumulate, accumulate, accumulate. The concept that I borrowed for the book is minimize your mistakes, keep the ball in play and let the other guy make mistakes, you come out as a winner.
In investment management, if you could just reduce the number of mistakes you've made, you would come out as a winner. The easy summary of all that is, if you index, you won't be making any mistakes. You have to choose the right index, that's fair. If you index, you won't be timing the market, you won't be trading too much, you will get excited about something you just heard from a friend of yours who heard from a friend of his that looks like it might be a really great idea. That's where all of us make mistakes.
Plus, index funds are super low cost. They don't have any operating expenses that active management have, and they don't have the taxes that active management has. There's a lot of different little bits and pieces of accessibility than in another places. In adding it all up, turned out to be over a long period of time. Huge.
You talked about golf and tennis. Can you explain why money management is a loser's game?
If you look at what you have done as an investment manager and compared to what would have been done if you were indexing instead, you will see that you've come out with a lower rate of return almost all the time. It's because of the things you were doing, trying to win, trying to be better that actually didn't pay off.
You wrote about the loser's game in 1975 in the Financial Analyst Journal. How has the perception of active management changed since then?
Well, at the time of the original article, most people thought, “Oh, that's a cute idea. Of course, it doesn't apply to me. I can beat the market anytime I want to.” If they look back over their shoulder at the prior 20 years, that was a wonderful time for active investment management. World changed, world changed, the world changed, the world change in many, many, many different ways. It was just at the time when, in my view, active management was losing its moxie and was causing more trouble than was doing good.
Since then, it's gotten harder and harder and harder to be an active manager, and successful at the same time. More and more people have accepted indexing is a perfectly rational way of taking advantage of the realities of the market, then not getting suckered into doing things that actually do you harm. It does take a sense of humour, and it does take an appreciation for history to realize, I know you're wonderful. I know you're terrifically talented. I know you work very, very hard, but you're actually not helping yourself, or your clients.
Wow.
Let me just drop, what to me is a absolute bombshell. If you look at the investment results of active managers, mutual funds being the only really good source of information. But take all actively managed mutual funds in a 20-year time period, 85% to 90% of them will fall short of the index that they chose as their index to beat. You’re a large cap value manager, I'm a small cap growth manager, whatever type of manager we want to be. We design how we're going to be, really good at that. We choose the source of information will be most helpful to us. We develop the trading skills that would be most effective, then we go out there in the world, free to do anything that we really want to do to advance our cause, and 85% to 90% of us will fall short.
At the end of 20 years, if you said, “Oh, gee. All we have to do is find the really good guys, then we'll be in great shape.” Sorry. Of those that happen to do well, about 85%, or 90% of them will fail in the next 20 years.
You talked about how the market changed up to the point where you wrote your 1975 paper. How has it changed since then?
Oh, boy. Count the ways. It's just astonishing when you go back and look at it. In the days gone by, we all were terribly proud that we had slide rules. I had a long, long testatrix. It was an amazingly good slide rule. None of us had computing power. The amount of information that was available was really limited because most of the major securities firms did not do research and certainly didn't distributed generally.
Goldman Sachs had just started. One salesperson had just started putting out a four-page flyer once a month. Merrill Lynch had no research of any kind, as a matter of principle, business purpose. Really quite different than we're used to now. The positive side for investors, it was really quite marvellous. Companies were so interested in being sure that their stock was fairly priced, that you would be able to have private meetings for an hour, hour and a half, two hours, not just with the chief executive officer, or the chief financial officer, but with several different division managers.
You can do that every couple of months. They really appreciated that you knew a lot and they would help you by filling in any information you didn't know for sure, and so you could develop for yourself if you were willing to do the work, an enormous competitive advantage. Then if you looked at who was the competition, and I think most of us way underestimate this change. If you go back to the late 60s, and early 70s, in and around that period, if you looked at trading on the New York Stock Exchange, the volume would have been between 3 and 4 million shares. Today, it's 1,000 times larger or 2,000 times larger in terms of volume.
Volume is really a big change-maker. The composition of the trading volume is an even bigger change maker. If you look back in the 60s, for example, 90 plus percent of trading was done by individuals who bought or sold every year, or two, or three. Half of what they did when they bought or sold was in transactions in AT&T, because it was the most widely known company and they had nice dividends, and it was quite safe. That's 90% of your competition. They're all amateurs, and they have no access to any information. They're just doing what they think might be a sensible thing to be doing.
Phrases like, taking candy from babies come to mind right away. It was really not fair competition, if you had the privilege of talking to management and really getting an understanding. In those days, to beat the market was not hard. It was fun. You could pretty reasonably expect to add 200, maybe 300 basis points a year on average, over time, because you had a terrific competitive advantage.
Since then, virtually everything has changed. It's changed to make it tougher and tougher and tougher. If you believe as I do, the Darwinian concept of there's always this continuous competition, and the best will be prevailing. If you look at investment management today, the talented people in investment management are superb. They're wonderful. They're smart as the Dickens. They've all got graduate degrees. They've all got organizations that work all the time. They have access to a tremendous amount of factual information.
They were using computers in other ways, constantly trying to get small, comparative advantages. If you talk to active managers today about how did you do your research on that particular company? You'd have to stand back and be really impressed. This amount of rigour and the study care and the attention is just amazing. Much to be admired. One problem, and boy is that a big problem. Everybody who is inactive management is really terrific. Everybody who's in active management works all the time. Everybody who's in active management is really skilled at the work because all the other people been driven out of the business.
Then you look and say, but what has changed? It's just one after another after another. Start with, how about change in information? Well, back in the 60s, there might have been as many as 5,000 people worldwide, involved in active investing. More than half of them would have been in the US. The next largest group would have been in the UK, and then have been sprinkled with people, some in Hong Kong, some elsewhere, trying to figure out what they could do to get a comparative advantage.
Well, today that 5,000 has been increased to something like 2 million, 2 million people does transform the nature of the market, and anything. Okay, so participants are really good. They also have terrific educations. You have MBAs all over the place today. That was a very rare thing years ago. You have PhDs, you have MDs. You have people who've got all kinds of skills in there competing all the time. The intellectual level has been raised and raised and raised. Then you think, “Well, what kind of equipment do they have?” We had slide rules. What do you guys have?
Well, we have more computing power in our pocket than an IBM 360, which you guys were all excited about back in the 1960s. We all have computing power more powerful, and we have Internet, which gives us continuous access to all the information we ever want anywhere. We've got Mike Bloomberg’s wonderful terminals and we can manipulate and do any kind of analysis we want to do anytime we want to do. Most of us have one at home and one at work. Then some people have one in the limousine taking them between home and work because they don't want to miss anything. Just imagine what an extraordinary up-calling and flow of information that produces for everybody. It’s just astonishing reality of change.
The trouble is, everybody's got a Bloomberg terminal. Everybody's got Internet access. Everybody's got terrific computing power. Everybody's part of this fabulous worldwide network of information from all the major securities firms, with branches in all the major economies around the world, piling information into the system and making it available to everybody who wants to compete. It's a very highly competitive thing. It's doing what an economist was saying, that's what markets are for, what they're doing and doing quite beautifully.
Do you think the sentiment toward active management has perhaps, become a bit too negative?
Well, it depends who you are. If you look at my own fuse, you'd say, “Jeepers Charley, you're pretty negative about active management.” If you looked at how many people are in active management, you'd have to say, it gets larger and larger every year. If you'd look at the number of people who are studying for the CFA Program, or for an MBA in investment management, that gets larger and larger every year. If you look at the number of clients, it seems to be going up fairly steadily.
If you look at the amount of money, you'd say it's flowing towards indexing at a pretty substantial clip. That's very substantial clip in terms of money doesn't really affect how many people are involved. It's not as obviously connected as number of people, substantial institutional flows have been part of it. People who go into indexing often do something else as well in the active area, so they don't go entirely into indexing. I think there's a lot of room yet for people to decide.
The evidence is awfully powerful. I know that I'm better than anybody else. I'm just not going to waste my time trying to prove that I'm better than anybody else at investment management. I'm going to do other things where the rewards are going to be more likely and more substantial. It's hard. We're all trained. If you work harder, you'll do better. If you do your homework in school, you'll get higher grades. If you work hard in your initial job, you'll get faster promotions. Everything that we're taught as children and as we learn and experience, if you'd work harder at something, you're almost sure to do better. That's very often true. But not always and this is one of those places where you've got other things you should concentrate your energy in.
Charley, we are already converts to indexing, as are many of our listeners. You've already touched on some of the arguments, but for someone who may not yet be sold on indexing, how would you convince them?
Ask them to look at the data. Ask them to look at the causal factors that are causing the data. Then ask them to keep a record of their own investing. Accurate record. Boy, you've learned a lot from your own record saying, “Son of a gun. Who would ever thought that I, good old me was part of the problem?”
That's a great one. Keeping a record of your own investment decisions is a good one. Is there a type of investor that should not invest in low-cost index funds?
I don't know of anyone that I would say should not. It gives you a couple of examples. Most of us, who knew him at all, had the highest regard for David Swensen, who was the Chief Investment Officer for Yale and turned into one of the truly outstanding records of achievement. It'd be very hard to make an argument, David Swensen should have been indexing. He started, when he first took on the responsibility, he had most of the fund in indexing. Then gradually found ways that active investing of the kind that he was particularly good at doing could make a justified case that you'll get an incremental return by not indexing, but by being active.
Some of that was portfolio structure. He was not exactly the first, but one of the first to consider hedge funds. He's one of the first to get involved in private equity. He was one of the first to get involved in venture capital. He was one of the first to get involved in creative real estate. That is a man who was extraordinarily bright, a rigorous thinker, and very disciplined in everything he did. He found that there were places he could get a competitive advantage structurally because parts of the market weren't being all that well attended. Big change from then to today.
Today, many other institutions are doing hedge funds and private equity and real estate and international and all kinds of other things like that. At the time, he was able to create quite a significant comparative advantage. The second thing, all of us who knew David had to stand in awe at his skill. He was awfully good at selecting individual managers. He had over 100 different investment managers. If you looked at this list, I promise you, you would not have been able to say, “I know 20 names on this list.” Most people couldn't come close. Most people would say, “I know two or three names, but the rest I've never actually heard of.”
Incredible.
He was constantly working to find really talented investment managers who were doing things that other people weren't thinking about, and relatively small in their assets under management compared to their skill set. Put those two together and then staying disciplined, disciplined, disciplined. Oh, and by the way, he was particularly skilled at managing risk. Paid more attention to managing risk by a long shot, than he did to rate of return. He had a consequential substantial success.
I think, it's very realistic for the largest investment organizations, with gifted individuals and a great leader, to put together a record of achievement that is actually better than you would be able to achieve through indexing. I've had the experience of seeing that in the King Abdullah University of Science and Technology, which in the world of education, is one of the three or four largest endowments. Now started out at 20 billion dollars, it's now comfortably over 40.
With a discipline and a skill set that you have to be in awe of. Just persistent, wonderful, first rate, careful word. They still do a fair amount of indexing, but where they find the comparative advantage that's large enough to step up, they'll step up. Any individual person, for almost any organization, the chances of being able to develop the information about active managers to be able to make shrewd, profitable choices of active managers are just way too low.
Candidly, you've got better things to do in terms of trying to figure out, what kind of investing is best for your organization, or for you as an individual? Defining the purpose of the investing is for most people where they could really do a lot of good for themselves by being very active about that part of investment management.
I want to dig more into that later. My understanding of the data on institutions that have attempted to replicate the Swensen Yale Model, most of them have not been super successful. Is that correct?
That's correct.
Even there, it's tough.
I majored in art history. I tend to go back and use that as an analogy. There are a lot of people who are painting pictures. A lot of people are painting pictures and actually making a reasonable, reasonable living doing it. There are very few people that are painting pictures that are going to be in the walls of the great art museums a 100 years from now.
I like that. Swensen as an artist. Very nice. We've been talking about index investing in general. I want to ask, Charley, what do you think about low-cost systematic strategies that seek higher expected returns in the market by owning riskier stocks, like small cap value stocks as an example?
First, indexing is an implementation strategy. If you don't have a strong opinion, then I think you should seriously consider global index funds, than say, basically, I don't have a strong opinion that I'm willing to live with for 10 years, or longer. I'm going to assume that I'll be wise to go where other people have made the best decision-making. I do emphasize global, as well as large cap, mid cap and small cap, the full spectrum. If on the other hand, you know for sure that you have a strong opinion and you want to exercise it, I have no problem with somebody saying, “I'm going to be – my one condition is that you're going to do this for a long, long, long time. Not that you're going to try it for six months, try it for 12 months, and then go do something else.” Because you can screw up indexing easily by jumping from one index to another index to another index because you're almost guaranteeing that you'll be making mistakes, because you'll get the same information other people have. It's already priced into the stocks that are in the index. You're just making trouble for yourself if you're willing to switch around and around and around.
If you're comfortable with large cap, small cap, your choice, you feel strongly about it, fine. I don't really get upset when somebody says, “Well, I'd really rather stay invested in America only.” For me, that's fine because it's such a large market and in such a large economy. It's got so much diversification. The operational skills that are brought to bear all the time are really very, very good. That's fine. You're probably wiser to internationalize your investing. But how people feel is a very important part of the reality. It's not how they feel today. It's how will they feel when it doesn't look like things are going the right way.
That's a little bit like the secret to raising teenage children, is to be able to take a long-term view, if you're going to get upset about what they did, or didn't do in a particular day, you're not going to have an easy time being a parent. If you're able to keep in mind, “No, no, no. By the time they're 30, they're going to be people I really like a lot,” you'll be fine.
Instead of trying to time, or beat the market, what should investors and advisors be focused on?
Oh, thanks for asking. I think this is really the most important message I could give to anybody. That is to be an active investor at figuring out who the hell are you? What is your real situation? I put it to you that almost every investor is different from almost every other investor. People talk about Harvard, Yale and Princeton as so they're three of the same. They are very, very, very different institutions in terms of what is their investment reality, and when you're managing the endowments for those institutions, what are you actually responsible for accomplishing?
The first and most important thing any of us can do as individuals, or as institutions, is to figure out what is it about us that's different? Then if you use individuals in as you’d say, playing field for a second, we differ a lot in terms of our age, our ability to save, how much we have saved, our attitude towards gifts to members of our family and inheritance. We differ in terms of our desires to accumulate for philanthropic purposes. We differ in terms of risk tolerance, or comfort. I mean, short-term risk tolerance and long-term risk tolerance, both. We differ substantially in how much we enjoy investing, and whether we're interested in it or not. Are we willing to spend a lot of time trying to figure ourselves out what makes us tick? What's our psychological weakness? What do we have to be protecting ourselves against? All sorts of things like that.
When you get all of those together, it's my own personal, simple summary, we're all unique. Each one of us is different. You and I wear eyeglasses, but I'm sure that your prescription for your eyeglasses is a little different from mine. You probably wear a different size shoes than I do. Your family likes you to wear certain colours more than my family likes me to wear. One after another after another after another differentiation. We are wonderfully different.
It goes down to things like our fingerprints are so different, that we can go to prison on the basis of their fingerprints, than our DNA. 500 years from now, people can identify who we were and what we did. Thomas Jefferson's descendants have been intrigued to find out that they can genetically prove that ancestry. If we just have a little bit of reverence and appreciation for the fact that we're all different, and then find out what's right for us and stay focused on what's right for us, I think we’ll be very, very well advanced.
The other thing that I'm really keen on is, most of us pay absolutely no attention when we're thinking about our investing. Think absolutely no attention, whatsoever, just parts of the total equation that are really important. For example, how many people really know how much is the value of social security that will be paid out to them year after year after year after year? If they just they went into the marketplace to try to buy it. How much would it cost to get a product equal to social security benefits? Almost nobody knows what the answer is. Well, why not? It's a terribly important part of your economic reality.
What is the difference between your home as an economic entity and your home as a very important part of your family life? It's an economic entity. If you ever had to, you could sell your home and downsize, or you might decide, “Hey, the kids growing up, we really want to downsize because it's a nuisance, trying to take care of this large house and all that sort of stuff.” Fine. Being able to look at the total picture of your finances is, in my opinion, very important. If you start with, for an example, somebody's 30 years of age and ask, how much should they have in fixed income investments? I’ll look at and say, “Gee, why would they have anything in fixed income investments, other than a reserve of modest beginnings, just to cover an emergency that might pop up?”
But look at the reality of their future, is that they're going to be able to earn and save for years and years and years. Then they're going to have social security on top of that. Maybe that'd be looking at all equity investment, or nearly all equity investment. If you say, “No, no, no. Invest your age in bonds.” At 30, you want 30% invested in bonds, or at 50, you want 50% invested in bonds. Why? Well, there may be people that for them, it's the right answer. But it's not going to be the right answer for most people.
If you could find out what makes you particular, you could probably do a great job starting from there to build an investment program that's really right for you and your family. I laugh and I give myself as an example. I'm cheerfully 85. Glad to be here. No complaints. If you said, “Well, gee. You must have mostly in bonds, aren't you?” No, I'm not. I don't own any bonds. I have no intention of owning bonds. “They’re all in stocks at your age?” Yeah. “Why?” Well, I'm lucky enough to continue earning a living. With a required minimum distribution, that more than covers our family expenses. We don't live a fancy life, so maybe that makes it easy, but that's covered.
What am I investing for? I’m investing to be sure my wife is comfortable, fine. What's her and mine jointly investing program? Well, it's for our kids. Is that it? No, it's for our kids and our grandchildren. Then the grandchildren average age is 15. Do they give a damn about what's going on in the stock market today? No. Will they care about what happen to the stock market 10 years from now? No. What they care about is when they're in their 60s, 70s and 80s, getting close to this time for spending, they would like to know that there was plenty, or ample.
How important do you think it is to have a well-defined investment policy statement?
That's a little bit like, how important do you think it is to be honest with yourself about what's going on in life in any other dimension. I think if you can't write down on one side of a sheet of paper what you're trying to do and how you're going about it, and give it to somebody who's a really smart cookie and a friend of yours, who will ask you tough questions and say, “You know, it's interesting. We've just asked you every question we can think of, and we've pushed and pulled, and there isn't a word on this document that we think we want to change.” How long would it take you to do that? Maybe a day. More likely, an hour and a half.
It could be the best, most valuable hour and a half you spent in your entire investment career. Then you are going to go back and look at it every once in a while. Many people recommend once a year, fine. Do it at Thanksgiving, so you could be appreciative. Do it at Christmas, if you want to. Do it on your birthday, if you want to. Do it on the 4th of July as another dimension of independence. Whatever way you want to go. Do it on a regular basis. Be sure that you're showing your wife, or spouse, husband what you've written down. Be sure that you're quite comfortable sitting with a friend who's a smart, tough cookie, saying, “Can you see anything in this that I should have changed?”
What can investors do to protect themselves from themselves?
That's a tough one. They should ask a psychiatrist. I'd love to give you a straight answer, but I think the main thing is study the markets enough so that you realize how skillful the price setting really is, and how hard it is for anybody to do better and say, “I'll take what's available.” The second thing would be, really, try to understand yourself. Putting it in writing and showing it to your spouse, or a friend can be a very, very good way of getting close enough to being accurate, so that you could say, “I find that very, very helpful.”
You got to recognize a starting line, all of us are always our own worst enemies. This is not because we're mean-spirited people. It's just that we're human beings and we tend to make mistakes. I think, Daniel Kahneman’s wonderful book, Thinking Fast and Thinking Slow, is probably the most valuable book for most people to read about investment management, because he explains how we do make systematic mistakes. We are going to continue doing it. It's in many, many cases been worked out that yes, 85% of people do make this mistake. Guess, I'm going to be one of the 85.
You've been doing this for a long time, Charley, and you've talked to a lot of people. What do you think is the most underappreciated action that individual investors can take to be more successful?
Oh, defining who they really are. Figuring out what the real problem is. I'm an art history major, but I had friends who were engineers. They all told me the same thing. Most of engineering is learning how to figure out and define the problem. Solving the problem is not very hard. Most of us candidly, with regard to investing, have not figured out what is the problem. If we just didn't realize, “Oh, yeah. That's really important.” Than if you could get everybody to sit down and spend even a day, trying to figure out what is the problem, they'd probably be well advantaged.
One of the problems that you've talked about often are fees, and that's been Vanguard’s main message. How well do you think the magnitude of the fee differential between index and active strategies are understood?
I'm afraid it's very, very little deep understanding, except those people who have gone through this thought process, and they said, “My God. Do you realize how much I was actually paying in fees? I don't want to do that anymore.” When you hear people say, “Well, how much do you get charged for investment management?” The answer is always, it's small. “Yeah, but what's the number?” Oh, it's only 1%. Then you say, “1%, of what?” 1% of the assets. “Yeah, but Charley, those your assets. What's the manager doing to make things better?” Oh, return? “Well, what's your expectation of return over the long-term?” I don't know, 6%, or 7%. Looks like a reasonably good bet from here.
“Okay, let's assume it's 7%. 1% of assets is what percent of returns?” About 15%. 15% is not small? Well, we always call it only 1% because we're habitual. Yeah, yeah, yeah. Actually, it's getting to be pretty large, isn’t it? Now, wait a minute. Index funds give you the same return of 7% and they charge you less than one-tenth of 1% of the assets. What are active managers doing for you? Well, they're getting a return that's higher than the market. I see. Now, what is the fee income above index fund fees for active management that will get you that higher rate of return? It was somewhere around 90, a 100, 110 basis points.
You're getting a higher rate of return than the market offers through index funds, by enough to make that worthwhile? Well, I hadn't thought about it that way. Actually, I don't get as much of a rate of return as I would have in index funds doing active management. You mean you're actually paying a fee that's infinitely larger than the value added of the service that you're getting? Well, come on. That's one way of looking at it. I get a lot of thoughtful attention. I get reports. I know the manager is working very hard all the time on my behalf. That's a nice way of describing it, Charley, but is it really, really, really true?
If you go to the cattle farm and ask the cattle, what do you think the deal is here? That's pretty good living. My friends are all here together. We get food anytime we want to. We get plenty of water to drink. We've stand around, moving with each other and that's all there is to it. It's funny how few of the steer would say, “And actually, we're going to give our lives over to the production of steaks and other things for other people.” You look at other situation. Amazed to me, in fact, to look at the reality, and then look at the way it's perceived. The perception is, you've got brilliantly talented people working hard for you all the time, that's true. That perception is that they're going to be able to make a real difference to your economic situation. That's very unlikely to be true.
What's very, very likely to be true is you're going to make a wonderful difference to their economic situation. I'm a graduate of Yale College and Harvard Business School. In both cases, I'm so glad that I went to the institutions that I do a fair amount of fundraising for each one. When I get every five years, it's time to have a reunion, it's time to start making the calls, I go to the list of the people that were in the investment management business, and I start there, because they've all got lots of money. They all feel quite appreciative of the way the world has worked out for them, and so they've got the right attitude. One thing I do do is I wait for an upmarket day. I don't call people to get a gift when the market is down for the day. I do it when the market is up for the day.
Active managers absorbing the incremental return that they earn. That's the key takeaway there. We had Jonathan Berk on our podcast. He had a paper a while ago that theoretically showed that that is exactly what you would expect in equilibrium, that the active managers collect all the incremental return in fees.
Charley, you've been telling this story of index funds consistently for decades. That's phenomenal. I want to ask, what have you changed your mind about throughout your career of doing that?
First of all, when I first got started in the early 1960s, I believed then and I would believe again, that it was a great time for active investment management. It was an absolutely spectacular period of time. They gradually shrank and disappeared. There was a time, just like there was a time when I was 18, 19 and 20-years-old and I could do all kinds of physical things that today, honestly, I wouldn't even consider. I would just swap one-for-one. There was a time when it was just wonderful to be an active investment manager, just getting started. Of course, indexing wasn't available anywhere in those days at all.
You've been around a lot of institutional investors, including sitting on and in fact, sharing Yale's Investment Committee. In your experience, Charley, how much respect do institutions and endowments give to low-cost index investing?
Well, I think the answer is for those who are serious minded, thoughtful and are up to the kinds of responsibility you're talking about, and therefore, virtually everybody who's carrying that responsibility. They all have a very, very high regard for indexing. Those who are particularly well-organized, particularly gifted and particularly deeply engaged in the networking and scuttlebutt network and trying to learn more and more, do pretty consistently believe that they can, at the top end, add a small incremental advantage than on the basis of very large assets they're responsible for, makes a great deal of good sense. Therefore, that they should be, and I can understand why they feel that way, active investment managers.
But where they are active investment managers is pretty far removed, in most cases, for the bulk of their assets from where individuals might be going. They are not investing in domestic US stocks as a principal activity. Might have a modest portion in US stocks. Their investing is international, very often in exotic kinds of investing, private equity, venture capital, hedge funds, where there is a wide spectrum of returns. For those who are very, very good at selecting, carefully choosing, the rate of return can be very, very rewarding. For those who are pretty good at that work, the rewards are not very great.
For those who are not pretty damn good at it, the rewards are actually a penalty, negative. As the spectrum of returns for venture capital goes from absolutely wonderful to absolutely embarrassing. We talk about the wonderful. We don't talk about the embarrassing.
What do you think about efforts to bring those exotic asset classes, like private equity and venture capital to retail investors? Vanguard has recently done this.
I'd say, Vanguard is unique operation. Vanguard has done this for institutional investors. You have to have substantial assets before they would even allow you to consider. Their strategy was, as I understand it, our clients are increasingly wanting to be able to make private equity investments. Let's see if we can find a talented, wide-spectrum, private equity manager that we could relate to, the same way we relate to the managers of stocks, bonds and other outside manager roles. If we could find such an organization that's got a wide diversification in its range of capabilities, as proven they can go through a change in leadership over time because they've had successive generations and leadership and has values comparable to what we at Vanguard hold, and we can negotiate favourable terms, we'd feel pretty good about that.
That I think is very carefully done, disciplined selection choice, and they don't expect to be in the top quartile. What they would like to be as in the second quartile with some confidence. It's only for long-term investors, and only substantial investors. They've tried to work it out, so that work to find a source of supply that is comfortable for the long-term, probably won't be one of the very best. Probably won't be, “Oh, my God. You got to see what I've been able to do.” Probably be pretty damn satisfactory results and heavy on the assurance that they've got the right kind of organization to work with. Best I can tell, people that I've talked to, that seems to be exactly what they've accomplished. It was to fill out a need that they felt their clients had for something that they weren't able to do in the past, and they wanted to have a fuller capability.
Makes sense the way you explain it. Do you view investment management as a profession?
That's not a fair question. I think it should be at all times a profession. I think, the skills brought to bear are ones that we would most of us put down as those are professional skills. People devote their entire life to doing investment management of a particular kind. Have got an education to be able to do that. Are constantly learning and learning and learning in order to be able to do that, and do it with a tremendous amount of sincerity and commitment. Give it all they've got. In that sense, very definitely professional.
The reality of the world is that if you said, “Okay, certain characteristics are professional. Other characteristics are commercial. As you look at the blend of characteristics in investment management organizations, which are dominant?” and I regret to say that in my own personal experience, the dominance is on the commercial side. You can tell one clue to that is, well, what's the record of the person who's in charge of the organization? What's the record of the person who's next in line to be in charge of the organization?
Almost always, those individuals have been chosen because they are really good at business management. They may have originally started out in the profession, but they've developed over time their distinctive competencies. They're good at organization management, motivating people and turning in economic results that are favourable to the owners of the investment organization, i.e. the profits. They're really good at it, which is why they've got those very difficult jobs.
They are not as focused on the professional disciplines of serving and caring greatly about what's really right for clients because they have to be doing what's really right for the owners, because that's their job. They blend that with doing what's right for the clients, as much as they can. If you got right down to the nut-cutting the final choices, most of the time, their final choices would be, what's really, really in the interest of the owner of the organization. One example of that is do they grow larger than they probably ought to? Yes, they do. Because incremental assets are extraordinarily rewarding. The owners really notice that.
Where do you see the biggest future opportunities in our field of investment management?
Virtually everywhere.
Wow.
There's so many different kinds of investment management that people can undertake. There's so many different ways in which they can increase the value of their organization's competence to serve clients, and then take it out to clients that are not yet getting that service value. It's a wonderful field in that sense of being able to go in virtually any direction you want to go, if you're skilled enough and diligent enough to make it all come together. I think, each individual has to be careful to choose for themselves because there are so darn many choices.
In your book, you talk briefly about the difference between price discovery and value discovery. I'd love it if you could talk about that. Maybe, also, what role do you think financial professionals should play in value discovery.
Price discovery is getting the correct price. If you look at anything in economics, the function of markets is to bring willing buyers and willing sellers together at a reasonable cost to themselves to participate in transactions. The better and better the market, the more and more exactly the price will be the correct price. That is that there's no way you can get a competitive advantage by shopping around, or looking for something different.
If you look at investment management as an activity, it has resulted in correct pricing of companies and of various sorts of assets; real estate being an obvious one. Every kind of asset is in one way or another, being priced in a market. If you take all the investment assets, the pricing of investment assets around the world has been substantially improved, not necessarily year after year, after year, but decade after decade after decade, for sure. Then it has resulted in some very nice benefits to the economics of one country after another, one industry after another. It's been really a terrific positive experience.
Price discovery has been exceedingly well developed, partly because we make all sorts of information available to all sorts of investors. Then encourage them to try to find what is it that they would most like to have. Do you have an aggregating process that results in price discovery that is simply superb? If you look at value discovery, the way I think about it, value discovery is for each individual investor and for each institution, what is it that they really, really want to have as a result of their long-term investment program?
There, I think we've got way bigger opportunities to do better and better and better, by being more careful about defining what is it that we would value if we were to get it and being accurate about that. Not whimsical, but short run. But long run, what really is the purpose that we have in mind as to what values we're trying to realize? I do believe that investment advisors can make a terrific difference in that field, and make a wonderful contribution long run to their client’s total experience in investment management.
I completely agree with you. I find it to be unbelievable that you wrote about that in your book when you did because you were thinking way ahead of your time, I would say.
Nice of you to say. I wouldn't have said it that way. I’d just say, I’d put it down on paper, I'm sure lots of other people were thinking about it the same time. I probably would have gotten it from several other people and then said, “Hey, they're all saying the right thing. I'm going to write that down.”
While we're complimenting you here, Charley, I must say, what I find so fascinating about your work is, you're at the cross section of looking at and understanding companies and businesses, as well as your prolific career in the asset management business. Specific examples, your excellent book, Capital, as well as What It Takes are two phenomenal books about companies. With that as a setup, what do you think has made Vanguard so successful as a company?
Well, it's a interesting combination. First of all, some of it is good luck. Some of it is extraordinary guts, blended in with anger and determination, in a way that you look back on and say, thank goodness, that all came together. Some of it is an opportunity that almost all of us would like to have. That's to be part of an organization that really is devoted to serving clients, and has a clear vision of how to go about serving clients. That works. It works for us as an organization and works for the clients that we like to serve.
Then develop a culture internally that allows people to feel deeply committed to that mission, or purpose. Then the leadership that allows the organization to get better and better and better at what it’s trying to do. All of those things have come together in Vanguard. It's easy to forget today, when Jack Bogle first got going at Vanguard, he had almost nothing. His mission was to be the administrative back office for a group of mutual funds that were actually losing assets year after year after year. Jack never loved the back-office work. He was really good at sales. He cared a lot about creativity, strategic moves. He was extraordinarily gifted at innovation.
Jack never loved what was the total job of Vanguard. He got going pretty quickly, then he got lucky. Money market funds came available. Jack realized, “My God. Vanguard could do a money market fund, not at 1% of assets, but at a fraction of that. If we get bigger, we could make the fraction smaller and smaller and smaller.” Money market funds just happened to come at the right time. He grabbed hold of it and ran with it. That led to bond management.
Once again, if you're in a bond management business, bonds are bonds are bonds. A really good bond manager won't differ very much from another really good bond manager in rate of return. If the fees are different, everybody looks at it and you can't deny it. It's in black and white. It's there right in front of your very eyes. You can't listen. Then John Neff, who many people don't know about today, but in John's time, in the 35 years that he was an active manager of the Windsor fund, John turned in the best record of any investment manager that was in a mutual fund organization. He did it in terms of rate of return.
What the special extra was, he also did it by risk management the whole way through. He had the lowest risk level and the highest rate of return. Not every year, but over every five-year period. It just table thumb, table thumb, table thumb, turned in wonderful investment results. That attracted a lot of attention.
In and around the financial community, people said, “Hey, look. You get Neff, and it's a terrific value and the fees are low. If you're going to have any money market fund, for God's sake, go to Vanguard. If you're going to have bond management, for goodness sake, go to Vanguard.” All of a sudden, there were three different ways in which Vanguard had a really significant differentiation in what it was able to offer. People started talking about it, talking about it, talking about it. That really is what lifted off Vanguard as an organization. Don't forget, Jack Bogle was still a driven man, trying to strive and find a way to be stronger, better, whatever.
He was gifted at finding ways that would leave other people saying, “Jackie, you’re sure that's a good idea?” Well, by the time he'd done all his homework, he was pretty damn sure he was on the right track. There wasn't a perfect human being by any stretch. I think, the reputation that he accumulated over time was partly, Jack Bogle’s greatest development, or invention because he created an image and reputation for who he was that was absolutely wonderful. It wasn't necessarily always true, but it's still pretty inspirational.
Your book, Inside Vanguard, does a great job of telling that incredible story. When you look at some of the words you used to describe Vanguard, determination, God's anger. These are powerful, energizing words. Are themes like this consistent with other successful businesses that you have studied?
I think almost every organization that gets started in that starting period, that's exactly what it's all about. Almost every entrepreneur that I know is motivated in early stages, in part by anger, in part by self-confidence, in part by a dream of what they would be able to do, if they ever get their chance and they're determined, they're going to see if they can make that happen. It's a wonderful reality. I think the amount of energy and determination that has to be brought to bear, like a coiled spring, to do something as entrepreneurial successful is really something else.
If you don't have that absolute ferocious determination, and I hope it won't upset people to realize, and often it's anger, often as, “I'll show those guys, or I'll show that guy, or I'll show my dad, or I'll show the world.” Some of that is, “I am going to prove that I can do what I'm going to do.” If you don't have that fire in the belly, you're very likely not to have the drive to go through the rough and tumble of getting something pulled together and start it up and up over the hill, then starting to really make an impact.
A great thing about this country, in my opinion, is they're very large numbers of people who've got that determination to be successful. But it won't be just, “I would like to be successful.” That's very, very nice. You've got to have some driving force that will take you through the cold, dark, winter days when you're still struggling, then trying to raise the money, trying to get the clients, trying to get the people to join with you. There's a lot that goes into getting a company up and going. If you've got that drive, this is a great country in terms of receptivity to new ideas, new people, new organizations. Actually, as a nation, we celebrate the new thing. It's terrific.
You have had an incredibly productive career of thought leadership, writing, speaking, and I'm sure many other things behind the scenes. What have you learned about personal motivation and productivity throughout your career?
That's a tough question. Particularly when you start with what I've just been saying. It's an interesting combination of different factors at different stages. One is, it really matters to have a good idea of how you could add value, or be of real value to other people. It does help if you're in a nation where there are fairly large number of those other people. It helps if you have had an experience working in an organization that gave you an opportunity to see good skills, and also lack of skills mixed together and to realize, if I could stop doing some of the things that other guy was doing, and just concentrate on doing the good things, I think that would make a nice difference.
As I said before, you got to have a terrific amount of determination. Some of that determination is with yourself, and some of it is with your family. Then some of it is with your friends. You've got to be willing to share the positives in a very generous way with other people, so that they can say, “No, no. It's not Jack's firm or John's firm. It's our firm and we're really doing it together.” When you get to that stage, then I go back to, you need to have a culture that is centred on serving clients because everybody would like to do a good job that's really worthwhile. Boy, does that make a nice difference. When you've got a high motivation, we're here to do something we're proud of, a big, big difference. Second thing is to recruit rigorously and carefully and reason, make that a high priority. The very best organizations have all made recruiting the very best people their first and most important priority because they know darn well that the firm they're going to be in 10 years is the firm that is composed of the people they recruit now. Very, very standard procedure. But not very often done and implemented.
Then, if you've got an organization that's innovative, then some of the innovations will be unique to a specific situation. Some will be innovations that you can use several different times. Some will be innovations that you can use many, many, many times. Then some of the innovations of the way in which you change your organization, to be responsive to opportunities and challenges go along the way, all with a long-term focus on building the organization, through the right people to serve the right people in a systematic way.
It's awfully easy to say out loud, but all of these things are absolutely essential. One of those essentials is leadership. The job of leadership is to be sure all the different component parts are being brought together all the time and kept at their highest level of value-adding contribution to the total picture. It's also one of the greatest ways to spend time. If you're going to have a career, why not do something like that, and just be full of privileged opportunities to do something that you can be terribly proud of.
Our final question for you, Charley. How do you define success in your life?
Basically, it's being deeply pleased with the way things worked out. That you can look back on your life, or your career and say, “I've enjoyed what I did. I was challenged to my best levels of capability.” I didn't get out of my own skill set, so I was never out there doing something that might have been at risk for other people, or for myself, or for my organization. I learned a lot along the way and developed a great many friendships with the people that I was serving, as well as the people that I was competing with.
Then if you could put all those together, I think you'd find yourself feeling very deeply satisfied with what you have. Finding purpose in life is a personal, or private mission. Then being able to bring it into the reality that enjoyed along the way and enjoyed the privileges of really great friendship with wonderful people, who know what you're doing and why you're doing it and hold respect for it, to me, that would be the total picture.
Notice that I did not say, "And it was well rewarded financially" because I don't think that financial rewards are anywhere near as important as the spiritual, or personal, or emotional rewards that go with, no, you did something that you wanted to do, that clients or friends really wanted you to do, that you did in a way that they're all feeling pretty damn good about.
Wow. Well, I must say, Charley, this has been one of my career highlights to meet you and get a chance to talk with you. Thank you so much for joining us.
Cameron, you know I’ve had a wonderful experience. Thank you very much for the invitation.
Thanks, Charley.
***
I'm telling you, man. That thing in your book when I read that, because you wrote that a long time ago. It seems to me at least, that it's relatively recently that the field of financial advice is starting to focus more on helping people live good lives, as opposed to generating the best possible rate of return. To read those words written so long ago is just wow, mind-blowing. Amazing.
Well, you're very, very generous, and I love your – be careful. If you said, what really has contributed to your things working out so well for you, there’s one four-letter word that comes immediately to mind over and over and over and over and over and over and over and over again. It's luck. Just an incredibly lucky break to be an American, to be in this era, that you look back over the last 50, 75 years. What a wonderful time. Getting a good education was a normal thing. Jeepers creepers. Wasn't it terrific? Yeah, you’re darn right. Then, to get into the investment management business, just as it was getting started, and to realize it was going to be a global business. Just an unbelievable privilege.
Unreal.
Is there an error in the transcript? Let us know! Email us at info@rationalreminder.ca.
Be sure to add the episode number for reference.
Participate in our 23 in 23 Reading Challenge:
23 in 23 Reading Challenge — https://rationalreminder.ca/23in23
23 in 23 Reading Challenge on Beanstalk — https://pwlcapital.beanstack.org/
Participate in our Community Discussion about this Episode:
Books From Today’s Episode:
Winning the Loser's Game: Timeless Strategies for Successful Investing — https://amzn.to/3FrNKmt
Inside Vanguard — https://amzn.to/3TlwrcG
What It Takes: Seven Secrets of Success from the World's Greatest Professional Firms — https://amzn.to/3Thgm7z
Capital: The Story of Long-Term Investment Excellence — https://amzn.to/3FpiHb5
Figuring It Out: Sixty Years of Answering Investors' Most Important Questions — https://amzn.to/3LknZZ8
Links From Today’s Episode:
Rational Reminder on iTunes — https://itunes.apple.com/ca/podcast/the-rational-reminder-podcast/id1426530582.
Rational Reminder Website — https://rationalreminder.ca/
Shop Merch — https://shop.rationalreminder.ca/
Join the Community — https://community.rationalreminder.ca/
Follow us on Twitter — https://twitter.com/RationalRemind
Follow us on Instagram — @rationalreminder
Benjamin on Twitter — https://twitter.com/benjaminwfelix
Cameron on Twitter — https://twitter.com/CameronPassmore