Forty years ago, Charles Ellis characterized active investment management as a “loser’s game.” From the perspective of the mid-1970s, Ellis argued that since institutional investors had come to dominate the U.S. equity market, they could no longer generate market-beating returns by taking advantage of less well-informed amateurs. Investment management had become a game played by professionals against other professionals, and the way to win was to make fewer mistakes than your competitors. Since Ellis wrote, the trends he identified have continued in force — institutions’ share of assets has grown, portfolio turnover has increased, and managers have become more skillful.
This morning, John Authers of the Financial Times again characterized active management as a loser’s game, this time with special reference to the poor performance of most active managers in 2014. There are three reasons why 2014 has been so challenging:
- First, most active managers fail most of the time. This is a consequence of what Sharpe called “The Arithmetic of Active Management,” and follows from the professionalization of the investment industry. Since only half of the assets under management can have above-average returns before costs, and since active management costs more than passive indexing, the average active manager is at a disadvantage.
- Second, there is little evidence of persistence in the success of active managers. For example, the likelihood of finding a manager who will be above average for four consecutive years is about the same as the likelihood of flipping a coin and getting four heads in a row.
- Third, active managers were especially challenged in 2014 because of the low level of dispersion in the U.S. equity market. Dispersion measures the return differential between the average stock and the market index, and is a good proxy for the level of opportunity for active managers. If dispersion is relatively wide, the opportunities to profit from stock selection are relatively large; when dispersion is narrow, the opportunities diminish. And 2014’s dispersion may be a record low.
When Ellis wrote in 1975, the alternative to an unsatisfactory active manager was another (putatively-superior) active manager. Since then, there has been dramatic growth in the availability of indexed investments. In 2014 more than in most years, an investor who was willing to accept the market’s return outperformed a large majority of active investors. One way to win the loser’s game is not to play at all.