The Index Revolution

Charles D. Ellis draws on his distinguished 50-year career in investing to make a very strong case for indexing in his recent book The Index Revolution: Why Investors Should Join it Now. He acknowledges that collectively professionals used to be able to use intelligence, discipline, and early access to information to beat the market, but that this is no longer true today. His arguments are clear and thorough.

We might wonder whether the modern failure of investment professionals is a sign that past professionals were smarter. Ellis explains that this is not the case. In the 1960s, “Active investment managers were competing against two kinds of easy-to-beat competitors. Ninety percent of trading on the New York Stock Exchange was done by individual investors. Some were day traders ... [and] others were mostly doctors, lawyers, or businessmen.”

“Fifty years later, the share of trading by individuals has been overwhelmed by institutional and high-speed machine trading to over 98 percent.” “In a profound irony, the collective excellence of active professional investors has made it almost impossible for almost any of them to succeed.” “The specter of underperformance that now haunts active investing will not go away.”

Ellis says there are 4 big reasons for indexing today: “(1) the stock markets have changed extraordinarily over the past 50 years; (2) indexing outperforms active investing; (3) index funds are low cost; and (4) indexing investment operations enables you as an investor to focus on the policy decisions that are so important for each investor’s long-term investment success.”

Active managers saw the threat of index funds early on. In 1977, posters appeared in “the offices of investment management companies nationwide depicting Uncle Sam stamping ‘Un-American’ on computer printouts and the words ‘Help Stamp Out Index Funds. Index Funds are Un-American.’”

Interestingly, despite the threat from low-cost index funds, the cost of active management soared over the decades. Up to the 1970s, “explicit fees were low, typically one-tenth of 1 percent per year.” Clients seemed to believe that active managers could overcome much larger costs. “As a strategy consultant to investment managers from 1972 to 2000, I witnessed this process of explaining fee increases many times and never observed a negative reaction by the clients of any manager.”

High fees are tolerated in part because “nobody ever actually pays the managers’ fees by signing a check for hundreds of thousands of dollars. Fees are conveniently and quietly deducted by the manager from the assets being managed. Out of sight, out of mind.”

Ellis isn’t a fan of “Smart Beta” factor investing. “If a factor works, investors will notice, move in on it, and reduce or even eliminate the real risk-adjusted advantage seen previously by earlier investors.”

Although much of the book is focused on the U.S., Ellis has some advice for non-U.S. investors when it comes to stock asset allocation: “Investors based in New Zealand or Spain or Canada should be comfortable investing more than half of their investments outside their smaller home markets.”

Ellis advises young people to focus on owning stocks more than bonds because assets outside your portfolio such as “home, future income, and future Social Security benefits can all be thought of as close to stable value fixed-income equivalents.” Personally, I think future income for most people is riskier than they realize, but I still agree with Ellis that young people should ignore stock market price moves and own stocks.

I highly recommend this book. It is likely to help those who know little about index investing the most. Those who pursue active investing should read this book and be able to explain clearly why Ellis’ arguments don’t apply to them. Those who index their investments but need a refresher on why they should stay the course can benefit as well.