The Index Revolution E-Book

Charles D. Ellis

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 199

Veröffentlichungsjahr: 2016

Beschreibung

The evidence-based approach to a more worthwhile portfolio

The Index Revolution argues that active investing is a loser's game, and that a passive approach is more profitable in today's market. By adjusting your portfolio asset weights to match a performance index, you consistently earn higher rates of returns and come out on top in the long run. This book explains why, and describes how individual investors can take advantage of indexing to make their portfolio stronger and more profitable. By indexing investment operations at a very low cost, and trusting that active professionals have set securities prices as correctly as possible, you will achieve better long-term results than those who look down on passive approaches while following outdated advice that no longer works.

"Beating the market" is much harder than it used to be, and investors who continue to approach the market with that mindset populate the rolls of market losers time and time again. This book explains why indexing is the preferred approach in the current investment climate, and destroys the popular perception of passive investing as a weak market strategy.

• Structure your portfolio to perform better over the long term
• Trust in the pricing and earn higher rates of return
• Learn why a passive approach is more consistent and worthwhile
• Ignore overblown, outdated advice that is doomed to disappoint

All great investors share a common secret to success: rational decision-making based on objective information. The Index Revolution shows you a more rational approach to the market for a more profitable portfolio.

Leseprobe

THE INDEX REVOLUTION

Why Investors Should Join It Now

Charles D. Ellis

Cover image: Spirit of ‘76 painting © Steve McAlister/Getty Images, Inc.

Cover design: © Paul McCarthy

Copyright © 2016 by Charles D. Ellis. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

ISBN 9781119313076 (Hardcover)

ISBN 9781119313090 (ePDF)

ISBN 9781119313083 (ePub)

Dedicated to my friends, the pioneers of indexing:

Jack Bogle,

Dean LeBaron,

Jim Vertin

CONTENTS

Foreword

Introduction

Nine Silly “Reasons” Not to Index

Notes

Acknowledgments

Part One: Over 50 Years of Learning to Index

1: My Half-Century Odyssey

Notes

Part Two: The 10 Good Reasons to Index

2: The Stock Markets of the World Have Changed Extraordinarily

3: Indexing Outperforms Active Investing

Notes

4: Low Fees Are an Important Reason to Index

Notes

5: Indexing Makes It Much Easier to Focus on Your Most Important Investment Decisions

Notes

6: Your Taxes Are Lower When You Index

7: Indexing Saves Operational Costs

Note

8: Indexing Makes Most Investment Risks Easier to Live With

9: Indexing Avoids “Manager Risk”

10: Indexing Helps You Avoid Costly Troubles with Mr. Market

11: You Have Much Better Things to Do with Your Time

12: Experts Agree Most Investors Should Index

Notes

Appendix A: How About “Smart Beta”?

Notes

Appendix B: How to Get Started with Indexing

Appendix C: How Index Funds Are Managed

About the Author

Index

EULA

List of Tables

Chapter 1

Table 1.1

Table 1.2

Chapter 3

Table 3.1

Table 3.2

Table 3.3

Table 3.4

Table 3.5

List of Illustrations

Chapter 1

Figure 1.1

Index Mutual Funds

Figure 1.2

Index ETFs

Chapter 3

Figure 3.1

How Closed Funds Declined at Their End

Chapter 4

Figure 4.1

Fund Executives Expect Their Managers to Outperform

After

Fees

Guide

Cover

Table of Contents

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Foreword

As a person who has believed in indexing all my life, I am delighted to add my voice in support of the important message of this book. The Index Revolution is not only a history of the growth of indexing over the past 40 years, but also a call to those who may have been slow to accept this revolutionary method of portfolio management. If you are still attracted to high-expense, actively managed mutual funds (or, worse, if you have chosen to invest in hedge funds), Charley Ellis’s succinct arguments as well as his marvelous anecdotes should leave no lingering doubts in your mind: index investing represents a superior investment strategy, and everyone should use index funds as the core of their investment portfolios.

Every year, mutual-fund advertisements proudly declare that “this year will be a stock-pickers’ market.” They may admit that during the previous year it was all right to be invested in a simple index fund, but they say that the value of professional investment management will become apparent in the current year. Barron’s ran a cover story in 2015 and made the same case in 2016 that “active” portfolio managers would “recapture their lost glory.” In early 2014 The Wall Street Journal ran an article predicting that 2014 would be a stock-pickers’ market. Money managers have a number of clichés they use to promote their high-priced services, and “stock-pickers’ market” is one of their favorites. But year after year, when the results come in, low-cost index funds prove their worth as the optimal way to invest.

Indexing outperforms in both bull and bear markets. Active management will not protect you by moving out of stocks when markets decline. No one can consistently time the market. There is no evidence to support the claim that active managers do better when there is more or less dispersion in the returns for individual stocks. Nor is it the case that indexing does worse during periods of rising interest rates. While in every year there will always be some actively managed funds that beat the market, the odds of your finding one are stacked against you. And there is little persistence in mutual fund returns. The fact that a fund is an outperformer in one year is no guarantee that it will be a winner in the next. Indeed, Morningstar, the mutual fund rating company, found that its ratings, based on past performance, were not useful in predicting future returns. Their five-star-rated funds, the top performers, actually did worse over the next year than the lowest one-star-rated Morningstar Funds.

Morningstar found that the only variable that was reliably correlated with the next year’s performance was the fund’s expense ratio. Funds with low expense ratios and low turnover tend to outperform funds with high turnover and high expenses (even before considering the adverse tax effects of high-turnover funds). Of course, the quintessential low-turnover, low-expense funds are index funds, which simply buy and hold all the stocks in a particular market and do not trade from stock to stock.

Standard & Poor’s Dow Jones Indices published a statistical analysis in 2016 detailing the dismal record of “active” portfolio managers: As is typically the case, about two-thirds of active large-capitalization managers underperformed the S&P 500 large-cap index during 2015. Nor were managers any better in the supposedly less efficient, small-capitalization universe. Almost three-quarters of small-cap managers underperformed the S&P Small-Cap Index. When S&P measured performance over a longer time period, the results got worse. Over 80 percent of large-cap managers and almost 90 percent of small-cap managers underperformed their benchmark indexes over a ten-year period through December 2015.

The same findings have been documented in international markets. Even in the less efficient emerging markets, index funds regularly outperform active funds. The very inefficiency of emerging markets (including large bid-asked spreads, market impact costs, and a variety of stamp taxes on transactions) makes the strategy of simply buying and holding a broad indexed portfolio an optimal strategy in these markets, too. And indexing has proved its merit in the bond markets as well. The high-yield bond market is often considered to be best accessed via active investing, as passive vehicles have structural constraints that limit their flexibility and ability to deal with credit risk. Nevertheless, Standard & Poor’s found that the 10-year results through 2015 for the actively managed high-yield funds category show that over 90 percent of funds underperformed their broad-based benchmarks.

It is true that in every period there are some managers who do outperform. But there is little consistency. The best managers in one period are usually not the same as the outperformers in the next. And even celebrity managers like William Miller, who racked up market-beating returns over a decade, underperformed over the next several years. Your chances of picking the best managers for the next decade are virtually nil. You are far more likely to end up with a typical underperforming, high-priced manager who will produce returns for you that are lower than index returns by an amount about equal to the difference in the fees that are charged. Buying a low-cost index fund or exchange-traded fund (ETF) is the superior investment strategy. Trying to predict the next star manager is, in Charley Ellis’s famous words, “a loser’s game.”

Do you want more proof? In this slim volume, Charley presents a compendium of dismal results showing the futility of trying to beat the market. He also presents a number of additional arguments for indexing such as its simplicity and tax efficiency. And if you don’t believe me or even Charley, remember that Warren Buffett, perhaps the greatest investor of our time, has opined that all investors would be better off if their portfolio contained a diversified group of index funds.

In this readable volume, Charley describes how indexing was originally thought to be an inferior way to invest and even “un-American.” But as time went on and the evidence became stronger and stronger, the case for indexing became air tight. Indeed, the Ellis thesis, brilliantly explained in these pages, is that changes in the structure of the stock market now make it virtually impossible for money managers to outperform the market. Perhaps 50 years ago when our stock markets were dominated by individual investors, professionals, who visited companies to talk with management and were the first to know about company prospects, might have been able to select the best stocks and beat the market. But now we have fair disclosure regulations that require companies to make public announcements of any material facts that could influence their share price. And perhaps 98 percent of the trading is done by professionals with equally superb information and technology rather than by individuals. The irony is that in such an environment it is increasingly difficult for any professional to beat the market by enough to cover the extra fees and costs involved in trying.

The Index Revolution is not only a historical explanation of the growing acceptance of indexing over the past 50 years, but also an account of the personal evolution of a former believer in active management. Charley Ellis began his career as a firm believer in the usefulness of traditional security analysis and the potential superiority of professional management of common stock portfolios. He founded the firm Greenwich Associates that provides advisory services to the financial industry, and particularly to major investment managers. As a firsthand participant in the growth of the industry, Charley was in the perfect position to understand how vast changes in the environment made the traditional services of active portfolio managers increasingly less effective.

The paradox of security analysis and active stock selection is that as their practitioners become more professional and skilled, markets become more efficient and the search for mispriced securities becomes increasingly more difficult. Whenever information now becomes available about an industry or an individual stock, it gets reflected in the prices of individual stocks without delay. That does not mean that prices are always “correct.” Indeed, we know after the fact that prices are frequently “wrong.” But at any point in time, no one knows for sure whether they are too high or too low. And betting against the collective wisdom of many thousands of professional market participants is likely to be a “loser’s game.” Correct perceptions of mispricing are no more likely than incorrect perceptions, and active management adds considerable costs to the process as well as being extremely tax inefficient for taxable investors.

When Vanguard launched the first index, its chairman, John Bogle, hoped to raise $150 million in the fund’s initial public offering. In fact, only $11.4 million was raised, and the new fund was called “Bogle’s Folly.” The fund grew only slowly over the next several years and was denigrated by professional investment advisers and dismissed as “settling for mediocrity.” But experience was the best teacher. Investors came to realize that index investing was superior investing, and index funds with their low fees regularly outperformed actively managed funds. And index funds grew steadily over time.

Today, indexed mutual funds have over $2 trillion of investment assets. And exchange-traded (index) funds have approximately the same amount of assets. According to Morningstar, during 2015 investors pulled over $200 billion out of actively managed funds while they were pouring over $400 billion into index funds. These shifts are the latest evidence of a sea change in the asset management business. The index revolution is real, and the winners are individual and institutional investors who understand the superiority of indexing.

While indexing has grown sharply over the years, it still represents only about 30 percent of the total investment dollars. So the revolution still has lots of room to grow. Why so many investors continue to pay for expensive portfolio management advice of questionable value is testimony to the power of hope over experience. But, as Albert Einstein has taught us, “Insanity (is) doing the same thing over and over again and expecting different results.”

It is very clear that the core of every investment portfolio and certainly the composition of every retirement portfolio should be invested in low-cost index funds. If you are not convinced, and if you would like an expert like Charley Ellis to convince you that indexing is the optimal investment strategy, read this wonderful little book. It will be the most financially rewarding two hours you could possibly spend.

Burton G. Malkiel Princeton

Introduction

At the risk of “removing the punch bowl just when the party was really warming up”1 or offending my many friends among active managers, the purpose of this book is to show investors how much the world of investing has changed—changed so much and in so many compounding ways—that the skills and concepts of “performance” investing no longer work. In a profound irony, the collective excellence of active professional investors has made it almost impossible for almost any of them to succeed—after fees and costs—at beating the market. So investors need to know how much the world of investing has changed and what they can do now to achieve investing success.

While 50 years ago active investors could realistically aim to outperform the market, often by substantial margins, major basic changes have combined to make it unrealistic to try to beat today’s market—the consensus of many experts, all working with equally superb information and technology—by enough to justify paying the fees and costs of trying. For investment implementation, the time has come to switch to low-cost index funds and exchange-traded funds (ETFs).

Investors now can—and we all certainly should—use the time liberated by that switch to focus on important long-term investment questions that center on knowing who we really are as investors. We should start by defining our true and realistic long-term investment goals, recognizing that each of us has a unique combination of income, assets, time, responsibilities, experiences, expertise, interest in investing, and so on. Then, with a realistic understanding of the long-term and short-term nature of the capital markets, we can each design realistic investment policies that will enable us to enjoy long-term investment success. This is important work and should be Priority One for every investor.

All investors, whether individuals or institutions, should decide carefully whether to move away from conventional “beat the market” active investing. There are three compelling reasons to do this. First, indexing reliably delivers better long-term returns (as will be documented in Part Two, Chapter 2). Second, indexing is much cheaper and incurs less in taxes for individuals. In today’s professional market, such “small” differences make a big difference. Third, indexing frees us from the micro complexities of active investing so we can focus our time and attention on the macro decisions that are really important.

I hope that many remarkably capable and hardworking investment professionals will find this short book a “wake-up call” to redefine their responsibilities and the real purpose of their work. Many years ago, investment managers used to balance their intense focus on price discovery (beating the market by exploiting the mistakes of other investors) with at least equal emphasis on value discovery (helping clients think through and define their unique long-term objectives) and then would design for each client those long-term investment policy commitments most capable of achieving the long-term objectives. Because such customized professional counseling service “doesn’t scale,” while a focus on standardized investment products does scale and can produce a superbly profitable business, most investment managers have increasingly emphasized products. It’s time to “rebalance.” First, most investors can use professional help in determining optimal investment policies. Second, the old “beat the market” mantra is out of date and out of touch with today’s reality.

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. As hard data now show, over the long term the markets have gone through such extraordinary changes that it’s no longer worth the fees, costs, and risks of trying to beat them. That’s why the old money game is over.

The phenomenal half-century transformation of the securities markets and investment management have been caused by an amazing influx of talent, information, expertise, and technology—and increasingly high fees. As a result, the central proposition of active investing, which worked so well many years ago, has gone through a classic bell curve and become an almost certain loser’s game. (A loser’s game is a contest—like club tennis—in which the win-lose outcome is determined not by the successes of the winner, but by the mistakes and failures of the loser.)

Active investing, as now practiced by most mutual funds and most managers of pension and endowment funds, typically involves portfolios with 60 to 80 different stocks and annual turnover of 60 to 100 percent. As will be shown in Part Two, Chapter 2, more than 98 percent of all stock market trading is now done by professional investors or computer algorithms. Active investors are almost always buying from or selling to expert professionals who are part of a superb global information network and are very hard to beat.

Even in today’s highly efficient markets, a few exceptional investment managers* may outperform the market after fees, costs, and taxes. Many more will believe they can—or will say they can—than will ever succeed. And even for the few who succeed over the long term, the magnitude of their better performance will be small. To make matters worse for investors, there is no known way to identify the exceptional few in advance. What’s more, investors need to know that the “data” on past performance, sadly, are all too often distorted and so are seriously misleading.

Fortunately, neither individual nor institutional investors have to play the loser’s game of active investing. By indexing investment operations at very low cost and accepting that active professionals have set securities prices about as correctly as is possible, index investors know that over the long term, they will achieve better results than other investors, particularly those who stay with active investing—the once promising approach that is now out of date and, with few exceptions, doomed to disappoint.

Part One of this book explains my personal half-century odyssey from confident enthusiasm for active investing through increasing doubt as the market changed and changed again, culminating in my slow arrival at the now self-evident conclusion: The major stock markets have changed so much and fees and costs are now so important that almost all investors will be wise to change to low-cost indexing for implementation and concentrate where each client is unique and decisions really matter: investment policy.

In Part Two, you will find 10 good reasons most investors, both individuals and institutions, will be wise to index now or, at the very least, give indexing careful consideration. The first 4 are the major, undeniable reasons. The next 6 reasons are important, too. Here, briefly, are the reasons that will then be explained, each in its own chapter.