Charlie Ellis On Playing "The Loser's Game"

Charles D. Ellis, President of Greenwich Associates, wrote a seminal article entitled "The Loser's Game" in The Financial Analysts Journal for July/August 1975.

Ellis quickly offered a provocative and bold statement: "The investment management business is built upon a simple and basic belief: Professional managers can beat the market. That premise appears to be false."

He pointed out that over the prior decade, 85% of institutional investors had underperformed the return of the S&P 500 Index, largely because "money management has become a Loser's Game.…Institutional investors have become, and will continue to be, the dominant feature of their own environment … causing the transformation that took money management from a Winner's Game to a Loser's Game.

The ultimate outcome is determined by who can lose the fewest points, not who can win them." He went on to note that "gambling in a casino where the house takes 20% of every pot is obviously a Loser's Game."

Ellis went to the underlying economics of the matter: If equities provide an average return of 9% a year, and a manager generates 30% portfolio turnover at a cost of 3% of the principal value on both the sales and the reinvestment of the proceeds (a reduction in return equal to 1.8% of assets per year) and charges management and custody fees equal to 0.2% (low!), the active manager incurs costs of 2%. Therefore, he must achieve an annual return of +11% before these costs—that is, 22% above the market's return—just to equal the gross market return. (That 2% aggregate cost remains pretty much the same—although of a somewhat different composition—for mutual funds in 1997, 22 years later.)

While Ellis did not call for the formation of an index fund, he did ask: "Does the index necessarily lead to an entirely passive index portfolio?" He answered, "No, it doesn't necessarily lead in that direction. Not quite. But if you can't beat the market, you should certainly consider joining it. An index fund is one way."

In the real world, of course, few managers indeed have consistently been able to add more than those two percentage points of annual return necessary merely to match the index, and even those few have been exceptionally difficult to identify in advance.