Charles Ellis is a master story teller. When Ellis served on Yale Universitys investment committee from 1992 to 2008, his colleagues, who included David Swensen, went so far as to call the advice and wisdom he imparted through his stories Charleys parables. So when I decided to research whether alpha investment returns above what a plain old index fund would give you was just a fairy tale that the investment industry told itself at bedtime, Ellis was my guy. I asked the author of Winning the Losers Game and the man who wrote the foreword to Swensens landmark book on portfolio management to talk to me for a video series we were filming on the murky topic of why institutional investors rarely beat the market. It isnt a new problem (Ellis first wrote about it in 1972), but it has been getting steadily worse, and I believed I might be writing alphas obituary not good when your job is writing for a publication named Institutional Investor.
When the indefatigable Ellis called me back on a dreary day at the end of March, he graciously said no to the video, assuring me I would never want to interview him on film, as he doesnt know how to speak concisely. We then spent an hour talking about what prompted him to write Murder on the Orient Express: The Mystery of Underperformance, a short, Agatha Christieinspired piece in the Financial Analysts Journal last year in which he lays the blame for the inability of pension funds, endowments and others to invest well at the feet of the usual suspects. Everyone is guilty in Elliss estimation: money managers who overpromise, investment committees operating under bad governance structures, consultants who want to protect their franchises and poorly paid, thinly staffed institutional investors.
But the 75-year-old Ellis is polite, perhaps to a fault. He assures me that all these people sincerely believe theyre doing the right thing and that its hard to identify the son of a bitch (well, maybe not polite to a fault) who is truly responsible for the colossal failure to find alpha. To make his point, Ellis takes me on a long and often touching detour to explain how we can be part of the problem even as we are oblivious to the specifics of the role we are playing. He enlists the movie The Help, in which young, card-playing white women are blind to the tragic effects of segregation around them, to make his point that people in the investment industry are doing their best, even if inexorable forces are preventing them from delivering their promised product.
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Ellis, who founded consulting firm Greenwich Associates in 1972 to provide strategic advice to financial services firms, warns me he is going to stop talking, tells me how much fun he is having and asks how he can be of help. I tell him I want to know why the aggregate amount of alpha a measure of risk-adjusted excess return seems to be drying up. Why is it that investors can collectively discover and then quickly wring out all the value from an investment idea? Ellis has pointed to a lot of mistakes that investors make, like dumping funds at the worst possible moment; I ask him why a small-cap stock manager might have a harder time today picking stocks that will beat the average than he or she did in the 1980s.
I had evidence that it was happening. A few months earlier, before he landed at Credit Suisse in New York as head of global financial strategies, Michael Mauboussin had shown me statistics he had prepared for a Columbia University class on security analysis that he was teaching, illustrating that the margin of outperformance that is, alpha of U.S. large-cap mutual funds has been steadily shrinking for 40 years. The difference between the best and the average manager is narrowing, so the results get narrower, says Mauboussin. We saw it at the Olympics: The gold medalist wasnt that much faster than the athletes who won the silver and the bronze. Thats also happened in investing.