Saturday, July 18, 2015

in defense of active management

This month, Charley Ellis published "In Defense of Active Investing." The headline intrigues because Ellis is an indexing legend. In 1975, he wrote that active investing is "The Loser's Game." The article became an instant classic and was later incorporated into the curriculum for Chartered Financial Analysts candidates.

"The Loser's Game" argued that investment success lies not in hitting the most winners, as it's very difficult to strike winners while competing against hordes of other informed investors, but rather in minimizing the "losers" of turnover, costs, and taxes. (All right, taxes are my addition, as 1970s institutional investors never considered the subject, but Ellis would certainly have discussed them had he thought about retail accounts.)

He writes that, although it's difficult to win the Loser's Game, it is also "hard to lose." After all, the corollary of the criticism that active managers mostly hold the market is that active managers mostly hold the market. The biggest success for any prospective investor lies in getting into the game. After that, the leakage caused by active managers is modest. Besides, investing actively is good entertainment. "Since active investing is exciting and fun, investors who are losing a bit in purely economic terms surely enjoy a significant social good by being part of the action."

While I don't believe the case for active management is as hopeless as Ellis presents, as investors can improve their odds by seeking funds that share certain common attributes, I do not dispute his thesis. Active managers do set efficient security prices. They do help global markets to function smoothly. But there's no particular reason why you need to own them.

Ellis' "defense" of active management is in reality a highly effective attack. He came not to praise active managers, but to bury them.

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