Book Excerpt: Charles Ellis and the Index Revolution

In this exclusive excerpt from his upcoming book, the longtime consultant explains why he’s come to believe that active investing is ultimately a loser’s game.

“Chahley, Chahley, didn’t you learn anything about investing at Hahvud?” My supervisor, Phil Bauer, had just finished reading my first report — on textile stocks — at Rockefeller Brothers. He was not pleased. My report was all too obviously the work of a rank beginner.

Confessing the obvious, I explained that the only course on investing at Harvard Business School in 1963 was notoriously dull and dealt largely with the tedious routines of a local bank’s junior trust officer administering trusts for the family of a wealthy widow, Miss Hilda Heald. Meeting from 11:30 to 1:00, the course was aptly known as “Darkness at Noon.”

“Well, Chahley, the Rockafellahs ah rich people, but not so rich they can afford a complete beginnah like you! You gotta learn somethin’ about investin’ — and soon!” Before the day was over, arrangements were made for me to join the training program at a Wall Street firm, to learn the basics of securities analysis; to join the New York Society of Security Analysts so I could hear companies’ presentations and meet other analysts; and to enroll in night courses on investment basics at NYU’s downtown business school. Tuition would be paid so long as my grades were B-plus or better — generous terms and important for a married guy living in New York City on an annual salary of only $6,000. The fall term was about to begin, so I went to register for courses.

Arriving at a large room where a sign said REGISTRATION, I joined one of several long lines of 20-somethings and eventually stood in front of a card table with a typewriter on it and a young woman sitting behind it. “Special or regular?” she asked. Since I didn’t answer quickly, she rephrased her question: “Are you a special student or a regular student?”

“Can you explain the difference?”

“Sure, special students are just taking one or two courses; regular students are in a degree program. What’s your latest school and last degree?”


“Harvard Business School — MBA.”

“Oh wow! Harvard Business School! That’s really great! Well, since you already have your MBA, you should be in our Ph.D. program!”

“Does it cost more?”

“Same price. Why not try it? You can always drop out.”

Since nobody in my family had ever earned a Ph.D., I thought, “Why not?” It might be interesting and it would surprise my sister and brother, who had always gotten higher grades. I signed up with no idea that it would take me 14 long years to complete the Ph.D.

At NYU, I took two courses three nights a week, starting with proudly traditional courses in securities analysis, where the older faculty showed us how to analyze financial statements, estimate capital expenditures and their incremental rates of return, and create flow of funds statements. We also learned, during the 15-minute break between classes, how to dash two blocks to the hamburger shop, wolf bites of hot hamburger with gulps of cold milkshake to obtain a tolerable average temperature and dash back to class.

The theoretical part of my training came from courses taught by the younger faculty, who were excited about and deeply engaged in the then-new world of efficient markets, Modern Portfolio Theory, and the slew of research studies made possible by large new databases.

The practical part of my training took far less time: six eye-opening months at a New York Stock Exchange firm where training was led by Joseph R. Lasser, a superb financial analyst with a warm personality who enjoyed showing us that the accounts in financial reports were a language that could be translated into a superior understanding of business realities if you got behind the reported numbers.

A patient teacher-coach — “Let me show you how ... and then you show me you can do it” — Joe believed in clearly written reports because clear writing required clear thinking and thorough understanding of a company’s business. Joe also believed each report should tell an investment story that would hold the reader’s interest without ever promoting the stock beyond the two underlined words in the upper left corner of page one of each report: Purchase Recommendation.

As research director of a major securities firm and an accomplished financial analyst and investor, Joe was one of the first to become a Chartered Financial Analyst, or CFA. That new certification — presumptuously described as the equivalent of a CPA or a CLU, which at first it certainly was not — would soon require passing three all-day written examinations that assessed the candidate’s skills in financial analysis and portfolio management. Joe said he thought we should all enroll in the study program, take the exams and earn CFA Charters. So we sent off for the study materials and the list of books we should read, studied on our own and took the exams — invariably given each year on the most beautiful Saturday in June.

I was declared too young to take the third and final exam in 1968, and had to wait a year to mature. That same year, that third exam devoted the entire afternoon to one essay question: “Please Comment” on a recent Institutional Investor article brazenly titled “To Get Performance, You Have to Be Organized for It.” It advocated separating the operational roles of active portfolio managers from the policy-setting role of an investment committee. Frustrated to be told, “You’re too young,” I quietly savored a delicious irony: I had written that article for the January 1968 issue of II magazine.

The article championed pursuing higher rates of return by putting an individual, research-centered, swiftly acting portfolio manager in charge of managing a mutual fund or pension fund. While establishment banks and insurance companies were usually opposed to such unstructured investing because it seemed dangerously distant from fiduciary responsibilities, the high-performance results being achieved seemed compelling.

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Fifty years ago, it seemed to me and almost everyone else employed in investments entirely reasonable to believe that bright, diligent analysts and portfolio managers who were serious about doing their homework — interviewing senior corporate executives after several weeks of preparation, doing extensive financial analysis, studying industry trends and competing companies, interviewing customers and suppliers, and studying in-depth reports by Wall Street’s leading analysts — could regularly do three things: buy stocks that were underpriced, given their prospects; sell stocks that were overpriced; and construct portfolios that would produce results clearly superior to the overall market. Those of us privileged to be participants in the new ways of managing investments knew we were part of a major change. So, of course, we were all confidently active investors.

Active investment managers were competing against two kinds of easy-to-beat competitors. Ninety percent of trading on the NYSE was done by individual investors. Some were day traders speculating based on price changes and rumors. The others were mostly doctors, lawyers or businessmen who bought or sold stocks once every year or two when they had saved several thousand dollars or needed cash to buy a house or make a tuition payment. They were, perhaps, advised by a retail stockbroker who may or may not have read a two-page, backward-looking, non-analytical “tear sheet” from Standard & Poor’s. Even with fixed commissions averaging 40 cents a share, the broker earning a good living depended on high turnover in his customers’ accounts. With his focus on transactions, it was exceedingly unlikely that the broker had time for research or serious thinking about investment strategy or portfolio structure.

Over the years, researchers found that individual investors — not you, not me but that fellow behind the tree — lost, through their excessive efforts to “do better,” some 30 percent of the returns of the mutual funds or the stocks they invested in. For ambitious MBAs armed with in-depth research and easy access to virtually any corporate executive, and focusing entirely on the stock market, these innocent retail investors were not hard to beat: They were easy prey. Their status echoed a famous military observation by Heraclitus: “Out of every 100 men, 20 are real soldiers ... the other 80 are just targets.” 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.

Back in the 1960s, in private rooms at elite clubs and fancy restaurants, corporate executives in candid off-the-record talks outlined their strategic plans, their earnings expectations, their acquisition policies, their financing plans — and then answered probing questions by analysts and portfolio managers roughly the age of their grown children. Analysts following a company closely might meet executives at headquarters four to six times a year, conducting one-on-one interviews of an hour or more with five, ten or even more executives who told what they knew. These interviews were combined with information from important customers and suppliers and many pages of detailed financial analysis. A major research report might run over 50 pages — even 100 pages.

Back then, conservative bank trust departments and insurance companies were structured to be deliberate and prudent. Senior executives, with most of their careers behind them, met weekly or monthly to compose “approved lists” of the blue-chip stocks that their subordinates could then buy. In stocks, unseasoned issues were avoided, dividends were prized and buy and hold was standard to avoid taxes. In bonds, laddered maturities and holding to maturity were hallowed norms.

A dramatic change came into institutional investment management when A.G. Becker & Co. introduced its Funds Evaluation Service. It collected, analyzed and reported how each pension fund — and each manager of each pension fund — had performed, quarter by quarter, in direct comparison with other funds. When the reports came out, they would prove that the big banks and the insurance companies were underperforming the market — again and again — while the active managers were repeatedly outperforming. This changed everything.

A remarkable new desktop device could provide an investor who typed in the NYSE symbol of a stock with the most recent price, the day’s high and low, and the trading volume. Previously, an investor had to call a broker or, if he had one, watch the ticker tape that Thomas Edison had invented back in 1869. Like all the others, I worked with a slide rule. (Mine was a beautiful log-log-decatrix.) We filled out spreadsheets on bookkeeping paper with No. 2 pencils and rummaged through the New York Stock Exchange files of SEC reports, hoping to find nuggets of information.

The work was interesting, but nobody expected to make much money — unless you discovered a great growth stock, which was what we all secretly hoped to do. MBAs were uncommon. Ph.D.s were never seen. Commissions still averaged 40 cents a share. All trading was paper-based. Messengers with huge black boxes on wheels, filled with stock and bond certificates, scurried from broker to broker trying to complete “good deliveries” of stock and bond certificates. They are all gone now; automation displaced them years ago. Many other changes since then have been substantial, so a few reminders of what Wall Street was like 50 years ago will provide perspective:

  • Brokers’ research departments — then usually fewer than ten people — were expected to search out small-cap stocks for the firm’s partners’ personal accounts. One major firm put out a weekly four-page report covering several stocks, but most provided no research for customers.
  • Block trading — with firms acting as dealers rather than brokers — had traditionally been scorned as too risky by the partners of establishment firms, but was now starting to develop, if only in trades of up to 5,000 shares.
  • Computers were confined to the back office, or “cage.” Computers were certainly not used in research or on trading desks.

Donaldson, Lufkin & Jenrette, the research firm I joined, and several other new “institutional” brokerage firms were different from traditional Wall Street firms. We worked harder for longer hours than people at those firms, thought we were smarter, knew we had more education and were sure we knew much more about the investment prospects of the companies we studied and recommended to our clients.
Our self-confidence was reinforced by the media. Circulation at the Wall Street Journal was soaring, and major newspapers around the country were expanding their coverage of business and the stock market. The Money Game was a national best seller. It explained what “performance” investing was all about and why anyone who could certainly should get on the bandwagon with one of the hot-shot active investment firms.

The single objective of these new organizations was to maximize investors’ returns. The successful new investment managers achieved superior operating results because they were better organized for performance than more traditional investors. Capital productivity (not capital preservation) dominated the structure and activities of their entire organizations, and the efforts of every individual were aimed at maximizing portfolio profit. The new organizations, seeing the market differently than the traditionalists, redefined portfolio management and organized themselves to exploit a changing set of problems and opportunities.

The new investment managers were convinced that the traditional organizational structure had important weaknesses that could be reduced or eliminated by changes in management organization and method. The competent individual portfolio manager had important advantages over a committee in making decisions. In portfolio management, time is money, and the necessarily slow decision process of an investment committee looked very expensive in opportunity costs. Memoranda prepared for investment committees took analysts’ time away from productive research efforts. Formal procedures delayed actions, often until, because of price changes, it was too late to act.

“The flow of money to these new managers is impressive evidence that the public recognizes their success. Investment managers that are organized along more traditional lines should seriously consider the nature and importance of the new approach to investment management.” So I wrote and believed back in 1968. Only a few months later, though, I began to see a few clouds on the performance horizon.

In my work at DLJ, I was in almost continuous contact with the portfolio managers and analysts at major institutional investors in Boston and New York City. This privileged experience showed me that while each institution knew it had bright, experienced and highly competitive professionals, they did not fully realize that so did every other institution. “Performance investing is not nearly as easy as it looks to one of the noncombatants,” I cautioned in a new article. “Not only is performance investing hard to do, the most effective practitioners face serious problems that raise the question: Will success spoil performance investing? The problem with success is simple: You get too big, almost ‘money bound’ and increasingly limited to ‘big cap’ stocks and paying high tolls in transition costs to get in or out of each position, the costs of operation increase, and there is not enough profit from good ideas to go around. That’s why success is beginning to spoil performance investing.”

“You can observe a lot,” proclaimed America’s folk hero Yogi Berra, “just by watching.” As usual, he was right — as I would find out when studying the academic literature in preparation for my Ph.D. oral examination. While there were continuing arguments over specific questions among academics, they believed all the major concepts of market efficiency had been proved. Practitioners who ignored the evidence would continue to scoff, but the more data was gathered and analyzed, the easier it was to make a convincing, fact-based case that stock markets, while not perfectly efficient, were too efficient for most active managers to beat, particularly after fees. But that reality failed to discourage those devoting their time, skills and energy to beating the market and earning a handsome living through “active” investing.

At NYU, the younger faculty, committed to such new ideas as efficient markets and Modern Portfolio Theory, were in a Young Turks struggle with the Old Guard to take control of the Ph.D. program. My academic adviser made it clear that the only way I could pass the comprehensive exam, which he had personally designed, was to become proficient in the new thinking. So, of course, that’s what lay ahead: 18 months of reading articles and books about how and why serious academic researchers were convinced that, while there was still room for argument about the “strong form” versus the “semi-strong form” of market efficiency, extensive examination of the data then becoming available proved time and time again that markets were surprisingly efficient — and that analysts and portfolio managers, still using slide rules, were surprisingly inefficient in making decisions to buy or sell stocks.

Back in the late 1960s and early 1970s, the differences in the prevailing academic view of active investing versus the prevailing view of leading practitioners were substantial — and they have been remarkably enduring ever since. In one way, I was caught in a crossfire, but in another way, I had the best of both worlds. My Ph.D. degree depended on mastering the academic, but my day job depended on mastering the pragmatic.

There were, it became clear, two cultures on Wall Street. One, clearly taking control at university finance faculties, held traditional practitioners in disdain — evenly matched by the disdain in which practitioners held the academics. The two camps believed in totally different concepts, used different data and different methods to support their different beliefs, spoke and wrote in different jargons, communicated with different constituencies and continuously talked past each other.

Academics believed that, as a result of their inability to make superior predictions of security prices, either individually or in aggregate, investment managers were unlikely to outperform a passive buy-the-market-and-hold portfolio strategy. Their evidence supported the theoretical expectation: Professionally managed portfolios had, on average, done no better than the market. The academic world believed the evidence was both consistent and overwhelming. There was no reason to keep arguing. The conclusion was clear: Markets were too efficient for active managers to do better.

Most of the academic research had been reported primarily in journals not usually read by investors. Research findings were generally presented in mathematical formulations that were unfamiliar and might even be intimidating. Few books dealt effectively with the subject on a nontechnical level, and the seriously selective information clients had been getting through conventional communication channels continued to support the traditional view of investment management.

Few corporate executives read the academic journals reporting the theory and supporting evidence on indexing and the increasing evidence-based doubts about active investing. Academics, writing for their academic colleagues and using formal equations with Greek letters and arcane terms, didn’t care. Corporate executives were not part of their intellectual community.

Practitioners had not begun to fight. Nor did they feel any need to. Active management was obviously better. They knew they were smart, creative and hardworking. They saw opportunities every day. Oh sure, there might be rough patches here and there, but they knew they would win in the long run. After all, they were the best and brightest.

The difference between the academic and practitioner views back in the 1970s could easily be explained by observing both in an historical context. In the first place, the academic view was relatively new — less than ten years old. In practical terms, index funds had been in operation only since 1971, when Wells Fargo began managing a fund for the pension plan of Samsonite Corp. No index fund was available to individual investors. Also, the practitioners’ view was internally consistent, which gave it strength in resisting major changes in either concept or technique. Moreover, the notion of achieving superior results by devoting outstanding professional resources to the task of investment management was intuitively appealing.

Hindsight makes clear that active investing was going through the early stages of an elongated, half-century version of the classic bell-curve life cycle of innovation: initially small, hard-won gains; then larger and larger gains made more easily and more rapidly; then, at a somewhat slower pace, still more gains; then, even more slowly, smaller and smaller gains; then, after peaking, small declines that would then grow larger and larger.

As a group, today’s active investors are among the smartest, best-educated, hardest-working, most creative, disciplined and interesting people in the world — surely the most capable collection of determined competitors the world has ever seen. So if you want to know whether you can retain the services of an excellent team of stellar people, fear not. You can and with a little effort, you will.

You would not, however, be asking the right question. Every other investor will have the same objective and many will be equally able to select excellent managers. The right question is this: Will your chosen manager be enough better than the other excellent managers over the long term — after costs, fees and taxes — to regularly beat the collective expertise of all the many other investment experts? Alas, the realistic answer to this question is almost certainly no.

Here’s why. To beat the market by a worthwhile margin, a manager would have to outperform the best work of over half a million smart, experienced, creative, disciplined and highly motivated experts — all trying to beat each other after costs and fees. All these experts have superb educations and years of experience working with the best practitioners on a level playing field with the same wonderful technology, the same exposure to new concepts, the same immediate access to all sorts of superb information and the same interpretations and advice from the same experts.

How substantial must that outperformance be? Let’s look at the numbers: To outperform the stock market — now generally expected to average 7 percent annual returns — by just 1 percentage point requires a superiority in returns of over 14 percent (1 divided by 7 = 14.3). If the manager charges a 1 percent fee, the necessary outperformance zooms to nearly 29 percent (2 divided by 7 = 28.6). Even if fees are “only” half of 1 percent and beating the market by half of 1 percent is the objective (after fees, costs and risk), the manager would still have to be 15 percent better than the other experts — year after year. And that is the real challenge.

This was feasible 30 or 50 years ago, but not today.

As an investor, you will be investing for a very long time. Changing managers is so notoriously fraught with costs and risks that, if you could, you would want to stay with one superior manager. But the lesson of history is that superior active managers seldom stay superior for long and changing managers is both costly and difficult.

So here comes the real difficulty: Will you be able to select the manager today that will be superior in the future? Will that same manager still be superior in 20 years — or even ten years? If your chosen manager fades or stumbles, as most once superior managers have, will you be able to recognize the looming decline in time to act? And will you then be able to select another exceptional manager for the next ten or more years? The data on investors’ experience are truly grim. Money flowing into and out of mutual funds shows that most investors all too often work against their own best interests when trying to pick managers. (Institutions do too; on average, the managers they fire outperform the new managers they hire.) Starting from the date they earn their coveted ratings, top-rated funds typically underperform their chosen benchmarks.

Back in 1971, while I was still fairly optimistic about the opportunities available to active investment managers, the increasing difficulty of achieving significantly superior performance was becoming evident. The number of active investment firms had increased substantially and not all had been successful. In another article, in the Financial Analysts Journal, I observed: “Game theorists describe as zero sum those situations in which neither side will gain a significant advantage unless the other side suffers an equally significant failure. And if, over the long haul, the players are evenly matched, in skills, information, experience and resources, as professional investors today certainly appear to be, little systematic advantage will be gained and maintained by any of the players and their average annual experience will be to lag behind the market by the cost to play.”

When selling their capabilities, investment managers still exuded confidence in their ability to prevail. All those who got to selection finals had the gee-whiz charts of superior past results and the compelling projections of surefire winners, and they dressed their parts. Investors were sure they could and would find talented, deeply committed managers with impressive records who would beat the market for them. Institutional investors, often with the help of well-known consultants, in a bake-off with three to five finalists would choose the best. No matter that the rates of return were not risk adjusted. No matter that the record’s starting date might be carefully chosen to make the manager look good. No matter that the benchmark with which comparisons were made might be selected from a variety of possibilities. Investment managers soon learned that the dominant factors in most institutions’ manager selection decisions were presentation skills and “performance,” particularly over the recent few years.

Little did it matter that past performance has been shown to have almost no power to predict future investment performance. In the scramble to find “top-quartile” managers, there would be no interest in settling for “just average” or in passive investing. No matter that the prospective manager might select only certain funds that showed the best results. And no matter that the selected data for the selected fund for the selected period were reported “gross” of fees — before fees were deducted.

Meanwhile, active investment managers assured clients and prospects that they would beat the market by significant margins. In their drive to win more business — which would produce wide incremental profit margins — investment managers engaged in modest deceptions to look their best in review meetings, sales meetings, brochures and media advertisements. They would, wouldn’t they? Believing numbers don’t lie, few clients were familiar with the difficulties of evaluating long-term and complex continuous processes with small samples of only a few years of data — samples that often were seriously biased by retroactive deletions of failed funds or backfilling with retroactive additions of successful funds.

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.

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 individual or institutional 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, et cetera, et cetera. 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.

A few years after my classmates and I left Harvard Business School, a dynamic young professor named M. Colyer Crum created an entirely different course that caught the leading edge of what would become a major revolution in institutional investing. The first-ever course on professional investing, it was a phenomenal success. Within two years, it was taught six times each year to nearly 500 students. Only 100 of the MBA students did not take the course.

Professor Crum came to one of the early portfolio manager seminars I’d been leading for DLJ. At the seminar, Colyer insisted, with his usual provocative style, that those who did not accept the burgeoning new reality were doomed to experience disruptive innovations. Colyer invited me to be a guest speaker in his new course and then, after that one class, invited me to teach an 80-student section of his course on institutional investing.

Understandably, my wife did not react positively. “You are doing too much already, including studying for your Ph.D. You can’t teach a whole Harvard Business School course too!” She was right, of course, so I declined. But a year later, the “to die for” invitation was renewed. The demand for the course had surged and I would have two sections of 80 students. Accepting the invitation would require being away from home only one night each week if I flew to Boston as early as possible on the first day of classes each week. This would work if I cut everything close: take the 7:00 a.m. Eastern Airlines shuttle out of LaGuardia to Boston’s Logan in time to catch a taxi to the School — arriving just in time for class at 8:40.

Ollie’s Taxi Service agreed to pick me up at home at 6:00 a.m. that first morning and take me to LaGuardia, but Ollie overslept and came badly late, still in his pajamas. He promised to drive as fast and aggressively as humanly possible; I promised a big tip if we made it on time. Because of heavy snow during the week before, traffic was slow, but Ollie took chances. By the time we got to Eastern’s very temporary “terminal” at LaGuardia, it was already flight time. I ran 50 yards to the gate. (There were no TSA bag checks in those days.)

“Too late!” cried out the gate agent, as he saw me coming — and gestured to the Convair that was folding its stairway up and into itself. Seeing my intention, he barked: “You cannot go out there!” I pushed my ticket into his chest and ran out onto the tarmac. The pilot looked down at me from the cockpit. I gestured with both arms outstretched, palms up, in a silent plea for mercy.

Please. Please.

For the first and only time in my life, the plane’s stairs were re-extended. I scrambled aboard. Out of breath, I fell into a seat and buckled up, knowing that fate must be on my side — again. Unless something went terribly wrong, I was not going to be a disastrous hour late for my first class at HBS. At Logan, I ran to get the first taxi. More snow made traffic slow, but the driver knew a back route and, when I promised a $20 tip, drove as though he was late for class — including running two red lights. He earned the full $20 and I walked quickly toward my assigned classroom.

Working my way through the crowd of students, I was ten feet from the door to Aldrich 108 and just two minutes before the 8:40 start of my first class when I recognized the man coming the other way: Paul Lawrence, one of my favorite teachers. Knowing I was there to teach my first class — just seven years after graduation — he smiled warmly, and gently wished me the one thing I had already so much of that morning: “Good luck!”

The course went well, more than fulfilling my hopes. The last of the 34 sessions centered on a critical question: With all the analytical talent and computer power being gathered into the many new investment firms, was it possible that they would make markets so much more efficient that most investment firms would be unable to beat the market? Near the end of the last class, one of the students asked, “Charley, we all know the school does not allow the faculty to declare their own views because you want us to think for ourselves. But just this once, please tell us what you really think.”

Silence — and 80 expectant faces waiting.

“I believe that it’s clearly possible to organize a first-rate group of analysts and portfolio managers into an investment firm that can significantly outperform the market averages.”


“And ... I’m wrong!”

Class dismissed. •

This article is adapted from The Index Revolution: Why Investors Should Join It Now, published by John Wiley & Sons. Reprinted with permission from Charles Ellis.

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