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Charles Ellis: The ‘Glory Days’ of Performance Investing Are Over

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“Active management is behind us, not in front of us,” Charles Ellis told RIAs Thursday morning in a session kicking off the sixth annual Think Retirement Income conference in Boston. 

Ellis, founder of the international consulting firm Greenwich Associates and author of the newly published “What It Takes: Seven Secrets of Success from the World’s Greatest Professional Firms,” argued that income security in retirement has nothing to do with beating the market. Instead, advisors need to give more consideration to indexing, which will let them devote more attention to their clients’ needs and interests. 

“What needs to be done [with the client] is crucial,” he said, pointing to the many 401(k) participants who know little or nothing about investment diversification or risk, let alone how to take income from their savings in retirement. 

Ellis, whom Forbes has called an “indexing hero,” launched his case against active management by noting that fully 80% of people think they’re above-average investors, when in reality even so-called experts are unable to forecast the future. Among the reasons he cited for this human fallibility: 

  • Confirmation bias: We actively seek and retain information that confirms what we already believe.
  • The “our crowd” effect: He explained this with a quote from Nobel Prize-winning behavioral economist Daniel Kahneman’s book “Thinking, Fast and Slow”: “People can maintain unshakable faith in any proposition when supported by co-believers.”
  • Hindsight bias: We often blame poor results on mistakes by “bad people,” not on uncontrollable factors. Doctors, for example, are blamed when patients don’t survive. Success usually results from combining a little talent with a lot of luck, Ellis said.
  • Failure to admit defeat: We tend to stay too long with failed decisions, failed marriages and failed investments.
  • “Fight or flight” reactions: Another Kahneman quote, “The long term is not where life is lived,” illustrated Ellis’s point that emotions drive many investing decisions. 

In addition, he said, there’s no way to know which actively managed funds will outperform. Previous performance is “totally useless” as a predictor of future results, with the exception that funds in the bottom decile usually stay at the bottom. Referencing survivorship bias, Ellis said that since funds that do poorly tend to disappear, risk is underweighted in the selection process. 

In further support of indexing, Ellis contended that more clients will begin to perceive fees for active management as unjustifiably steep. Charging a 1% fee for managing assets may not sound high, but if a portfolio earns only 7%, that represents 15% of its return. “If you can get the same return [at less cost] from an index fund, what incremental value are you getting from an active manager?” he asked.

By going passive, advisors can focus their skills on making “strategically active” decisions about their clients’ long-term objectives, risk, portfolio structure, spending and liquidity. 

“The investment management world is not going to solve this problem,” Ellis said.

In his view, the “glory days” of performance investing are over. “We have huge problems in our country with retirement security,” he concluded. “We have far too many people who are dependent on a 401(k) and don’t know how to behave in savings, don’t know how to behave in investing. Just wait until they start having to take money out of their account.”

For more on Charles Ellis, see Investment Advisor’s August 2013 cover story on leadership.