The Index Revolution

Why Investors Should Join It Now

Charles D. Ellis

• Publisher: Wiley
• Year: 2016
• Print ISBN:
  9781119313076
• Edition: 1
• eBook ISBN:
  9781119313083
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

The evidence-based approach to a more worthwhile portfolio

The Index Revolution argues that active investing is a loser's game, and that a passive approach is more profitable in today's market. By adjusting your portfolio asset weights to match a performance index, you consistently earn higher rates of returns and come out on top in the long run. This book explains why, and describes how individual investors can take advantage of indexing to make their portfolio stronger and more profitable. By indexing investment operations at a very low cost, and trusting that active professionals have set securities prices as correctly as possible, you will achieve better long-term results than those who look down on passive approaches while following outdated advice that no longer works.

"Beating the market" is much harder than it used to be, and investors who continue to approach the market with that mindset populate the rolls of market losers time and time again. This book explains why indexing is the preferred approach in the current investment climate, and destroys the popular perception of passive investing as a weak market strategy.

• Structure your portfolio to perform better over the long term
• Trust in the pricing and earn higher rates of return
• Learn why a passive approach is more consistent and worthwhile
• Ignore overblown, outdated advice that is doomed to disappoint

All great investors share a common secret to success: rational decision-making based on objective information. The Index Revolution shows you a more rational approach to the market for a more profitable portfolio.

Part One
Over 50 Years of Learning to Index

1
My Half-Century Odyssey

Well into my second year at Harvard Business School (HBS), spring was coming, Boston’s snow was melting, and classmates were accepting job offers when one of them asked one day at lunch, “Charley, have you decided on a job yet?”

“Not yet. Several good interviews, but no definite offers. Why do you ask?”

“My father has a friend who’s looking for an MBA to work at Rockefeller. Could that interest you?”

Thinking he meant the Rockefeller Foundation, I said I was interested. “Great!” he said, “Expect a call from a man with an unusual name: Strange.”

So I soon agreed to meet Robert Strange—at his suggestion in the remarkably unremarkable third-floor “apartment” of three rooms off one open landing in an old Victorian frame house where my wife and I were living. At the appointed time, Bob Strange rang the doorbell and cheerfully followed me up the stairs. Sitting together on secondhand chairs that might have come from Goodwill, we began to talk. After half an hour, I knew I could learn a lot from a man as thoughtful, informed, and articulate as Bob Strange, so if he offered me a job I would take it. But while it was becoming clear that he did not work at the Rockefeller Foundation, it wasn’t clear what kind of work he did do. I’d better find out.

During the next half hour, I learned his work involved investing, a field I knew nothing about but that sounded interesting, and his employer was Rockefeller Brothers, Inc., which managed investments for Rockefeller family members and philanthropies they had endowed. The interview seemed to go well, and near the end Bob said, “Well, we’ve covered quite a lot of ground, Charley. Would you like to join us?” I said yes. Then Bob asked, “When would you like to start?” and, smiling, went on to suggest, “With vacations and all, summers are rather quiet, so why don’t you come in on Tuesday after Labor Day?” I said “Fine. I’ll be there,” and that was that.

After Bob left, I went to tell my wife, who had been discreetly reading in the bedroom with the door closed. “Good news! I got the job.”

“Great! What will you be doing?”

“Investing.”

“Sounds interesting! What will you get paid?”

“Gosh, I forgot to ask.”

Setting my pay at $6,000 was, I later learned, easy. That’s what the Rockefeller bank—Chase Manhattan—paid first-year MBAs and also what the Family paid beginning domestic servants.

That was in 1963. Few of my Harvard Business School classmates went into investments and only a very few went to Wall Street. Several went into commercial banking, almost always for the training programs and a few years of experience before moving on to a corporate job—but almost never for a career.

• • •

“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, Inc. 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 was notoriously dull, given by a boring professor and dealing 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. Instead of the usual class size of 80, the course had only a dozen students—all looking for a “gut” course where decent grades were assured because the professor needed students for his course. 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, Wertheim & Company, 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 New York University’s downtown business school. Tuition would be paid so long as my grades were B+ or better—generous terms and important for a married guy living in New York City on a salary of $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 twenty-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 PhD 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 PhD, 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 PhD.

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 Wertheim & Company. 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 Certified Public Accountant (CPA) or a Chartered Life Underwriter (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.¹ 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 recently published article brazenly titled “To Get Performance, You Have to Be Orga...

Table of contents

• Cover
• Title Page
• Copyright
• Foreword
• Introduction
• Acknowledgments
• Part One: Over 50 Years of Learning to Index
• Part Two: The 10 Good Reasons to Index
• Appendix A: How About “Smart Beta”?
• Appendix B: How to Get Started with Indexing
• Appendix C: How Index Funds Are Managed
• About the Author
• Index
• EULA