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Is Active Investing Really a ‘Loser’s Game?’

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When Charles Ellis writes a book exhorting investors to buy index funds, it rattles those of us who have spent our careers in active management. Ellis, after all, wrote two glowing forewards for Yale University’s David Swensen in his book, “Pioneering Portfolio Management,” a bible of alternative investing. It was Swensen’s success investing in hedge funds, private equity funds, real estate and timber that played a large role in persuading institutional investors to consider alternatives to the traditional 60% stock–40% bond portfolio. That shift is also evident in the growth of the mutual fund-hedge fund hybrid, better known as liquid alternatives, as a slice of individual investors’ portfolios.

But now Ellis’ new book, “Index Revolution: Why Investors Should Join It Now,” argues that being an active manager is a “loser’s game,” meaning that investing is a zero-sum game — in every trade, one of the parties is making a mistake. “The world’s active managers are now so good and compete so vigorously to excel that almost none of them can expect — after fees and costs — to beat the consensus of all the other experts on price discovery,” writes Ellis.

Passive ‘Revolution’ Is Decades Old

The “revolution” toward passive management has been underway since 1976 when the Vanguard 500 debuted as the first index mutual fund. The trend has been gathering momentum as investors have become impatient with active managers struggling during the seven-year rally to outperform the indexes. By the end of July 2016, “Flowmageddon” resulted in $328 billion flowing out of actively managed U.S. mutual funds, while $401 billion flowed into funds that passively track an index, according to an August commentary from Morningstar. Hedge funds are also under pressure with $29.2 billion in redemptions in the third quarter, a level not seen since the first quarter of 2009, eVestment noted in its September Hedge Fund Asset Flows Report.

But there are a few caveats. Ellis’ thesis revolves around beating the market, but not every investor shares that goal. He rightly points out that successful investing is a long-term, disciplined, continuous process, and that “long-term investors need to maintain calm and ignore short-term price changes.”

However, when the S&P 500 Index dropped 37% in 2008, pension funds still had to pay retirement benefits to their retirees, creating a financial hole from which they are still digging out. For older individual investors, too, the specter of another 2008 fills them with dread because they fear they may not live long enough for their portfolio to recover.

This is why many pension funds and older investors have focused on risk management post-2008, not beating the market. Some pension funds are content with modest but reliable returns that meet their actuarial needs while many individual investors have piled into liquid alternatives seeking downside protection.

Bill Ackman, manager of the hedge fund Pershing Square, raised another concern about index funds in a letter to shareholders in January. He fears that the recent inflows into index funds could create a bubble. Today’s investors’ enthusiasm for indexing reminds him of the excitement they felt for technology stocks in 2000 when investors grew impatient with value-oriented funds as the tech sector soared. Value-oriented managers outperformed for years after the tech bubble burst, according to studies by research analyst John Dowdee for Seeking Alpha and Craig Israelsen for Financial Planning magazine.

Index funds are not a fad — they will last longer than did the enthusiasm for the Nifty Fifty or for covered calls. But they are not a panacea either. In my opinion, managers with a keen eye and a willingness to work hard and dig deep may find a way to keep delivering results for investors.

— Read Gross on Trump: ‘Populism Takes a Wrong Turn’; No Bull Market Bounce on ThinkAdvisor. 


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