Investing

The Loser’s Game

Charley Ellis, the renowned investment consultant, wrote an article for the Financial Analysts Journal in the mid 1970’s, entitled The Loser’s Game. The basic premise of the article was investing is a loser’s game. In other words, the winners in the investing game usually aren’t those investors actively attempting to make winning decisions. The winners, on average, are those investors who make fewer mistakes than everybody else.

Winners vs. Losers

In our post on mutual funds last week, we touched on active versus passive investing. Active investing is where an investor, usually a professional, attempts to select investments based on detailed analysis with the intent of performing better than a predefined benchmark, which is usually an index. Passive investing is where an investor simply holds an investment, usually in the form of a fund, that is designed to replicate, before fees, the performance of the replicated benchmark or index (i.e, S&P 500).

The active management business is highly competitive with armies of very smart and talented managers and analysts trying to do the same thing, beat the market or a benchmark. This high level of competition has made it difficult to establish and maintain a competitive edge for any length of time. A very select few managers have developed competitive advantages that enable them to consistently produce out-sized returns. Most everyone in the business knows who these managers are and seeks to work for these managers and/or to give them their money to manage.

As we highlighted last week, most active managers lose against their passive counterparts Think U.S. large cap equity mutual fund (growth, value or balanced) versus an S&P 500 or Russell 1000 index fund.

The Why

As we consider the body of evidence before us in the active versus passive debate, two question naturally arise. 1) Why are there still so many actively managed mutual funds when they perform so poorly relative to their passive counterparts? 2) Why do investors continue to allocate money to actively managed mutual funds if the odds of selecting an active manager that will outperform are so unfavorable?

Before addressing question #1, I wanted to discuss the importance of active management. Active management is an essential part of the investment markets and will likely always be. Through their diligent efforts, active managers exploit pricing and other market inefficiencies, helping to contribute to overall market efficiency over the long-run. However, that doesn’t necessarily justify the current universe of actively managed funds. After all, there’s only so many inefficiencies that can be exploited for profit before the law of diminishing returns takes hold.

Truth be told, the universe of actively managed funds is slowly shrinking as the passive investment movement continues to gain momentum. One of the last bastions of the actively managed mutual fund industry is the 401(k) market. Most 401(k) plans offer a wide selection of actively managed funds with few or no index fund (passive) options. Variable life insurance policies also continue to offer actively managed funds almost exclusively. As a result, there continues to be a somewhat sustained demand for actively managed mutual funds from group retirement plans and certain types of permanent life insurance policies.

The answer to question #1, effectively answers question #2. Passively managed funds have been taking market share, via fund flows, from actively managed funds for years now resulting in investors allocating less money to actively managed funds than they did 15 years ago. However, given the lack of passive investment options in many 401(k) plans and other financial industry products/vehicles individual investors are forced to allocate money to actively managed funds. In other words, many investors don’t have a choice to allocate to a passively managed option.

Passive Concerns

In recent years, some have warned of an ensuing asset bubble being inflated by increased flows to passive investing. When you invest in an index fund that engages in a full replication strategy, all the constituents of the index must be purchased and held by the fund. As a result, the rising tide in fund flows to passive funds lifts all boats, or all stocks in this case. I understand the premise of this argument but I’m not sure how to evaluate its validity.

An additional concern that has been raised is the passive revolution has led many individuals to believe they can manage their own investments. This argument is flawed, in my opinion, because the overarching concern of individual investors buying and selling at the least opportune times will occur no matter what the investment vehicle is, be it actively managed mutual funds, passively managed mutual funds or individual stocks. There’s enough evidence that shows the flaws of human emotions with investing to reasonably conclude individual investors will make the same mistakes no matter their investment vehicle of choice.

The Ongoing Debate

While the active versus passive debate is likely to continue for the foreseeable future, the facts are pretty clear. When Charley Ellis wrote The Loser’s Game in 1975, 85% of professionally managed funds underperformed the S&P 500 over the previous 10 years. As of the end of 2018, 76% of active stock funds underperformed their passive counterparts over the previous 10 years. While there may be periods of time when active management wins, it’s not sustained over time or by specific managers (in most cases).

I conclude with Mr. Ellis’ advice to active investment managers, which I believe is applicable to all of us who invest in a world where we often attempt to do too much.

“Don’t do anything because when you try to do something, it is on average a mistake.”