Link: https://capitalallocatorspodcast.com/2018/07/29/ellis2/
About Charley: Charley Ellis is the founder of Greenwich Associates, author of 16 books, and one of the most sought-after industry advisors worldwide.
Otter Transcript (Link)
1. The Case for Indexing
The Evolution of Markets
Investing Environment 50 years ago
- A device that reported the last, high and low prices and trading volume was cutting edge tech.
- The money game used to be like stealing candy from children. 10% of trading at most was done by institutions.
Sparse Institutional Players
- Statewide branches were allowed but interstate branching was not allowed for banks. So every mid-sized and larger city had two or three trust departments.
- The second group would be the major insurance companies in Hartford
- There was a little bit of mutual fund activity up in Boston, a little bit New York and there might be some on the west coast.
Abundant Retail Investors
Were they hard to beat? No way. They were easy to beat. The secret to successful active investing is to have what’s called, it’s a little bit nasty term, but called “willing losers.”
- Nice people who bought or sold once every year or two, usually an odd lot because that’s how much money they had. About half the time it was AT&T.
- They bought because they’ve been given a raise or a bonus or an inheritance. And they sold because they’re sending kids off to college or buying a home or some other sensible purpose that had nothing to do with what’s going on inside the market.
- They didn’t know very much, but that didn’t matter. They were buying a few blue-chip stocks that they read about in magazines.
Investing Today
The Talent Boom
The number of people involved in active investment management, best I can tell, has gone from less than 5000 to more than 1 million over 56 years. A major securities firm might have had 10 or a dozen analysts back in 1962. What were they doing? They were looking for small-cap stocks and interesting companies that might be interesting investments for the partners of the firm. Did they send anything out to their clients? No, not anything. Goldman Sachs didn’t start sending things out until 1964 or 1965, and there was just one of the salesmen thought it might be interesting idea to put out. Today, any self-respecting security firm is worldwide with analysts in London, Hong Kong, Singapore, Tokyo, Los Angeles. 400, 500, even 600 people trying to come up with insights, information, data that might be useful to clients. Anything that might be useful. Demographers, economists, political strategists, portfolio strategist and every major industry team. Every major company will have 10, 12, 15 analysts covering that company. And of course, then if you go to the specialist firms, there are all kinds of people and then there are intermediaries with access to all kinds of experts in any subject you might like. We’ve got 2000 experts. And anytime you want to talk to any one of them, just let us know. Glad to provide so an unbelievable, flourishing amount of information of all kinds, all of which is organized and distributed used as quickly as possible. Instantaneously, everybody.
The second thing is, Well, I hear about the CFA program. How’s that working out? Well, it’s off to a pretty good start. 135,000 people have passed the exams and another 250,000 people in the queue. The biggest crowd is the US, the second biggest crowd is China. The third biggest crowd is India. Its global. Yeah, of course its global. It’s all over the place — people want in on the good thing.
99% of trading is done by computers. Pros. We went from 3 million shares a day in 1960 to 5 billion today. And they know everything, you know, as soon as you know, and you can only buy from them and you only sell to them. How good a chance do you have of having this whole workout? And the answer is not very good.
Why so much competition?
- Well, first of all, the investment world is probably the highest paid line of work for large numbers of people. It’s wide open to everybody.
- You don’t have to retire at 65 or 70. You can keep going to 80 or 85.
- So the benefits around the edges that are quite nice. Anybody in the investment business knows once in a while, maybe once every 10 years, some unbelievably attractive opportunity, not really right for clients because it’s too small to specialize. But some really attractive opportunity comes up and says I would like you to invest in me. And it doesn’t always work out. But sometimes it can be beautiful.
Paradox of Skill
So there you are professional investor, you have noticed that you’re getting better and better and better over the years because your skills keep getting better. You’ve got better tools to work with…You have research services like you’ve never had before…more sources of information, you get it very, very quickly, and can act anytime you want.
…So does everyone else
As more and more people get the same kind of computing power, the same kind of information, the same speed of access, more and more people get more and more equal to each other.
- Flattening of info advantages
As recently as the 1980s, if you want to have a private meeting with senior management, all you had to do is show that you’ve done your homework that you were asking intelligent, probing questions, and that you had been coming back on a regular basis to this company. You were a serious investor. You could be invited to a dinner where the senior executives would talk about what their plans are for the future of the company. You could get a comparative advantage.
Today, the SEC now requires any public company that shares any useful information to any investor it must simultaneously make a diligent effort to be sure everybody gets that statement information. No more private conversations with management.
- The increasing role of luck
All of us are in mixture of skills and good luck, when the old days, good luck when all that important, the skills really made a big, big difference. But the skills that they have might have diminished in their percentage or relative importance because they’ve got these fabulous tools in unbelievable supply. And it’s that that makes them all increasingly equal. Even though they’re getting better and better. They’re getting less and less different.
- Playing bridge with all the cards face-up
Because everybody knows everything that everybody else knows, you may manage it a little differently, may make some mistakes a little differently. You may do some smart things a little differently. But it’s very hard to do significantly better than the other guys when they’ve got everything that you’ve got.
- The genie isn’t going back in the bottle
Candidly, there isn’t any doubt in my mind that that transformation has already taken place so forcefully. And for really good, understandable reasons. It’s not going to reverse.
Indexing is the Logical Response
Unprecedented breadth and quality of competition means efficient pricing. Active management is a losing game when you consider that, adjusting for survivorship bias, 84% of funds underperform.
Benefits of Indexing
- Top quartile performance, maybe top decile
- Minimize fees which are a huge drag.
- Lower taxes if you hold long-term
It’s passive and boring which helps you stay with it. Once you start transacting your behavioral biases undermine your goals.
“Passive” is poor label
He hates the word “passive” since it has labeled a great strategy with a very negative connotation word. Nobody wants to be called passive.
Caution on Smart Beta
- These things do have real merit over the long, long, long term. But if you think about it for a minute, when will sales organizations ramp up their selling effort the most? And when will nice people who haven’t thought about it as carefully as they might be most tempted to say “let’s go with it”, of course, is after a very good period of rising prices. So if value has been working very, very well, the demand for interest in buying into and the supply interest in selling people on value factor investments will rise to a crescendo at the top and then people get disappointed.
- The guys who have for years specialized in factor investing are going to find they can’t make as good a profit from doing it as they used to, because of the crowd. But they’ll still probably do a pretty good job for themselves and for their investors.
- Beware those who are in it because it’s a good commercial opportunity. Intermediaries that are in it because they think “hey, this is a new way to beat the market” are going to create a self-disappointing experience and it’s a shame.
Indexing in China may be a mistake
- The Chinese market is still dominated by retail investors which requires understanding how retail investors track past price performance and project future price performance.
- You might find yourself being indexed with foolishness rather than an index with rigorous professional expertise.
- This extends to indexing in emerging markets as well because there’s an unusual, different dynamic.
2. Concerns Over Indexing
Expensive Markets
There is concern that markets are not going to give what people need over the next 10 or 20 years. When Ted suggests that active management might outperform expensive public markets Charley replies with my favorite line in the interview:
Ted, Ted, Ted, you shouldn’t be talking that way.
He does not believe active will outperform.
How does Charley invest?
I’ve got two kinds of investment. One is index funds, which I’m happy with and just really comfortable with. And the second is an index fund equivalent in many ways –Berkshire Hathaway (he goes into his personal reasons for that).
Is there place for active management?
- The bar for inclusion is exceedingly high. Charley, himself, has access to the brightest investors and sticks with indexing himself:
I’ve used myself as an example. I have probably as good a network of friends in the investments world as anybody, particularly in the active management world. I know, because of service on a whole bunch of different philanthropic investment committees, I happen to know an awful lot of guys who are really talented at picking talented people. And I meet with them on a regular basis. So you think, “hey, Charley, you are probably as good a position as anybody to be able to pick and choose terrific active managers.”
Why doesn’t he do more of the “clever” things that can be done?
Easy answer. I’m not good enough. I don’t know enough.
- If not for Charley, who is active for?
Let’s be candid. You and I both have tremendous admiration for David Swensen. He should not be indexing. You know, why? He’s got all kinds of competitive advantage. Everybody loves David Swensen. Everybody loves the idea of working for Yale. He’s got the best team on his side, working with best managers anybody ever had. If you have a relationship with Yale, you know, it’s going to be a long term relationship, they average 10 years, their mentor relationship, something like 14 years. That’s the average, even though they usually invest with people at day one or before day one when they get into business. If you look at a list of their investment managers, you say, “geez, I don’t recognize most of those names.” That’s right. Nobody else does either. So a very unusual kind of investing. Guts, intellectual precision, and they do slightly better on asset mix. Half of 1%, maybe slightly better on manager selection, half of 1%, maybe got a team of 30 guys who are working to be sure they keep it up. And they got a network of friends and admirers all over the world, they get the best call, they do all kinds of vendors. So there are organizations like that and they’re not very many of them. Who else? There are pockets of managers who are extemely specialized and have their own money in the game, maybe some from outside investors. Basically a handful of managers with no real competition.
“If you are really an exception, you don’t have to index you can do something really different. But you have to be really good at your exceptional way of doing things. And you have to be not very widely followed or copied, because you’ve got to be almost alone doing it.”
- How about private equity?
He makes a criticially important point here about the inversion in the supply/demand of capital :
The real competition today is not by the investment managers to get your investment money. It’s by the people who’ve got money to get access to the best investment managers. And that’s been true for the last decade and venture capitalist have clearly true in private equity. And that’s a really important differentiation.
He continues:
I don’t think there’s any very large pool of capital that has not addressed the following question. We have a commitment to a higher rate of return than we’re now getting. What can we do to increase our rate of return? Answer: Private equity. Great, so why don’t we put not 10%, but 20 or 30%. Let’s say 33% into private equity. And we’ll do it in a very imaginative way. We’ll have a couple of specialists who work on selecting the private equity funds employed by US, Canada, we can’t pay very high salaries because our fund structure doesn’t allow us to do that. But we’ll do the best we can. And we’re going to make a major commitment to private equity. Fine. So does everybody.
What is the PE landscape as a result?
They have more money than they’d really like to have. In fact, they’ve got cash balances they can’t use yet. They’re competing with other guys with a lot of money too. So the entry price for private equity has been going up and up and up.
Some people say “we’re not going to raise more money, we’re going to stay as small as we can, we’re going to specialize in our particular niche, and we’re not going to take new accounts.” So that takes them out of the equation. There’s another group that says, “Well, you know, if everybody wants us, we’ll have to be opening up more capacity. We’ll just take the money. Let’s see if we can find a way to invest it as we go along. But might be difficult, but we’re gonna try and you know, it’s always worked so far.”
Well, you could have a huge flood of cash going into private equity. You can ruin anything by raising the entry price.
The theoretical limit of indexing
- What has to happen for the price discovery function to fail?
First, if you have 30% of the value of the market indexed, that’s not 30% of the trading activity, it’s a much smaller fraction. So what you have to do is have enough assets indexed to reduce the trading activity enough so that enough of that million plus people who are making their living as active investors comes down and down and down. Enough people need to decide “I’ve looked at it very carefully, and I’ve decided I’m quitting the business. I’m going into medicine, law, farming, ranching…”
What is it that people are going to go into that they think they’re going to find a more satisfying? Honestly, it’s not as good as it was, but it’s still the best game in town. It’s gonna be very hard to get people to give up on going into active investing.
- If they do cut back a lot, how much do you have to cut back?
You’d have to cut back so far that there was not a residual group of people who are pretty darn good at price determination. My own guess would be somewhere around 85% would have to quit, just because it doesn’t make sense anymore.
Mix in the combination of interest of active managers, overconfidence, and people’s desire to be better than average and it doesn’t seem likely that the competition would abate enough to undermine price discovery.
3. The Pension Crisis
Scope of the Problem
Public pension plans are impossibly underfunded
If you look at what are the biggest problems we as a nation have in the investments world, it’s pensions or retirement security. You can see it easily in the state and city funds that are seriously underfunded. They need 7.5% rate of return which they’re not going to get because they’ve got 25% in 2.5-3% bonds. They’re just not going to get it.
Households are underfunded
If you look at individuals, half the population does not have a retirement plan. For those that do 401k is increasingly dominant, taking over from defined benefit system. The average person approaching age 63.5 which is the retirement age in this country is thinking:
“I’ve got 165,000 smackers in my account. Why my wife and I are going to Florida to play some golf, some tennis, have some fun. We’re gonna have great years. We’ve earned it. It’s been a long long working run, but we’ve earned it it’s going to work out just fine.”
Except…
Anybody with any knowledge about investing knows right away — $165,000 if you take money out, from 63 years old to 85 or 90 is not enough. You’re not going to have anywhere near enough per year, cobbled together with social security to make anything like a decent connection.
Something over 65% of your life time health expenses are spent in your life six months. Well, that’s where half the bank for personal bankruptcies come from all kinds of trauma that goes with that as well assisted living expensive and dementia. So we’re going to have a real problem with old age, retirement security.
Political nightmare
So what are people gonna say?
“God damn it. I worked hard all my life I played by the game rules as everybody laid them out. And I was supposed to be able to retire at a decent age and enjoy retirement. That’s part of the deal.”
But the answer they will get back?
“Sorry, but nobody else understands that to be the part of the deal. And you’re on your own.”
So you will have a giant generation that is angry, focused, and motivated to do something about this false promise.
If you think we’ve had divisive politics in the past, imagine what it would be if you had millions of people and their relatives all saying “It isn’t fair. It isn’t right. These guys got screwed.” I think we’re going to have a terrible societal problem, political problem.
How Did We Get Here?
The retirement problem is rooted in an era of different needs and circumstances.
History of the retirement age
- Age 65 came from Social security which dates back to 1935,
which came from:
- Railroad Retirement act in 1923,
and even before that:
- Churchill and Chamberlain jointly put forward in the United Kingdom retirement at 70, but people thought that was unfair because the Germans used 65.
And here’s where we get to the root…
- German’s retirement age dates back to early 1880s
Baron Von Bismark tried to unify the German municipalities via technology namely the telegraph and the railroads. The telegraph combined with the post office allowed instantaneous communication anywhere in Germany.
We’re going to bring coal and iron ore from the rural and other areas to where the steel mills are and we’re going to build steel mills and have tremendous industry. And then railroads are going to be able to bring people from the cities out to the countryside for weekends, vacations can be normal, and we will bring from the countryside, fresh fruit, fresh vegetables, all kinds of wonderful things that for people to eat, it’s going to make everything terrific. That’s great.
But where are you going to get the workers to work on the railroad?
Offer lifetime employment.
You get them to come out of the forest because they can get lifetime employment. That’s terrific. What do you call that? That’s guaranteed. This is a commitment. It’s the honor of Germany. Okay. Let’s go.
So what happened?
Well after a couple of years there were accidents on the railroads. Trains ran into each other, people were killed. Public outrage and scrutiny.
What’s going on?
Well, let’s send a study group and find out what the heck is going with these accidents. Well, we found out what the answer is in the work. Laying tiles, lifting heavy ties, brailles, shoveling coal, all kinds of heavy work. They’re saying to the older guys in their late 50s and 60s, your too old for this kind of work. You take the easy job. You’ll be in charge of the switches.
Then what happened?
So the switches are being manned by guys in their early 60s. A beautiful summer’s day and no trains coming in for the next couple of hours, why not take a little nap? And they’re just taking a nap, forget to wake up, and the accident happened.
The solution?
Guarantees for life. Pay them not to work. To be cost effective find the min-max where it costs not too much to solve most of the problem. And the answer was 65. Most people don’t live to 65 in those days in Germany, but those who do are really doddering, so they will only last for another couple years after 65 anyway.
An obsolete model
We have inherited and retained a retirement model that is a poor fit for our post-industrial circumstances.
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- People live longer now. The ratio of non-working to working years has increased.
- People are able to work longer as manual labor’s share of the economy has declined.
Dealing with the Crisis
Extend your savings
- Take social security later…instead of 62 if you wait until 70.5 you make 76% more inflation-protected for the rest of your life. If you wait, you have fewer years in retirement, so they’re willing to give you a larger amount.
- Continue funding your 401k in your 60s. These are the easiest years to save money. So you can ramp up your savings, dump it into the 401k as fast as you could. (also there are catch-up allowances)
Do all of these things and your chances of being in serious financial trouble in retirement go from awful to not too bad. So if we act soon, we could make a big, big difference in what could otherwise be one of the worst problems our society has ever faced.
Why has this been so challenging to solve?
The big problem is nobody’s paying attention to it. It’s too late. Congress is dealing with politically urgent issues. We need to agree to raise the retirement age to 70 but it’s easy to say that when you are not a ditch digger or coal miner.
