Mr. Ellis opened the debate by changing the “passive” reference to “indexing”, arguing that the word passive came from engineering and the connotation really was the wrong sentiment for what it means to be an index investor. He cited that the big challenge with active management is that 84% of active managers fall short of their investment objective. The time, energy and knowledge that goes into actively managing an investment portfolio in line with an investor’s objective can almost be debilitating. Instead of micro-managing a portfolio, investors are better served to invest in strategies that follow indices to avoid unnecessary taxes, risks and time; ultimately, index investing will get an investor to where he/she wants to be.
Bill Miller acknowledged that he agrees to an extent. The advantages of indexing are true, he stated, and for investors broadly, index investing is a wise strategy. 70-75% of managers that claim to be active are in reality, what the academics call “closet-indexers.” These managers are typically bound by risk parameters and guidelines set by their Firms, often putting limits on how much can be invested in a particular sector or triggers for when to sell, that inhibit their ability to be truly active. Many investors will pick up return moving from a high cost closet indexer into a low cost indexing strategy. However, it’s key to note that while the costs of index strategies are lower, usually 5-10 basis points, their return will always be lower than the index when accounting for these fees. It’s like a wedge, the longer an investor holds an indexing strategy, the greater the underperformance. If you want active exposure, look for managers with high active share, an indication of how differentiated a strategy is from its benchmark.
Mr. Ellis admitted that he has a small percentage of his portfolio invested in active managers. He believes that the space is highly competitive, with over one million active managers vying for investor attention and dollars. They are all competing to capitalize on errors in the market place, and many are very good at it. He believes that investors should let those experts be the active managers.
Bill presented a framework to think about how investment managers source their edge:
- Informational: You know something someone else doesn’t know. This is very difficult to achieve and is fleeting. Laws are designed to prevent this.
- Analytical: Everyone has the same information, but you are able to weigh the impact or probability differently.
- Behavioral: Opportunities arise from the tendency of large groups of people to behave similarly. Understanding psychology, sociology, biology and other sciences has helped us to capitalize on this source of edge.
One topic on which both Bill and Mr. Ellis voiced similar opinions is in the ability for investors to destroy value by jumping around between managers and trying to time the market. Each cited studies that show when investors are considering investing in a manager, are they coming off a period of bad performance or good performance, as the bad performers then tend to do well and the good mangers tend to do poorly. Mr. Ellis made an interesting point that the original intent of the five-star Morningstar rating system was to give investors an assessment of past performance, as that’s on what it is based. It’s not designed to forecast future performance, but that is mistakenly how investors use the ratings when making decisions where to invest.
Bill went on to explain that over time, the economy has grown and the risk investors take is not a drawdown in an occasional bear market, but actually it’s being underinvested. Focusing on short-term volatility and not seeing the long-term picture is costly. Bill cited from Mr. Ellis’s book Winning the Losers Game: “The reason we study market history is to protect our portfolios from ourselves.” To the extent that you can understand how markets operate, the better able you can see the long-term picture. Humans are emotionally driven and can lead to irrational decisions when it comes to investing. This is why investors more often than not buy high and sell low.
Bill recommended that to pick top tier active managers, investors should look for a process that makes sense to you – not results. If the process is sound, the results will be there. You should align with the manager on their investment philosophy. It’s important to note how much the investor has invested in his/her own strategy, as this shows an alignment of objectives. Mr. Ellis added that character is important, as well as understanding the economic strategy of the Firm.
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