Jul 30, 2018 · 1h 18m · capital-allocators
Charley Ellis - Indexing and Its Alternatives (EP.62)
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gold bands on the timeline = statements, start to end. Hover to read, click to jump. CC turns on captions
In this episode of Capital Allocators, host Ted Seides interviews industry icon Charlie Ellis to examine why the structural evolution of financial markets makes low-cost index investing mathematically superior for most investors. Ellis also analyzes the institutional endowment model, private equity headwinds, the impending retirement security crisis, and timeless lessons on career leadership and personal character.
How this conversation actually went
Every chapter scored 0–10 on four independent dynamics. Hover any point for the reasoning behind the score. Ted holds 18.5% of the talking time here. How this is scored →
Ted as informed peer 4.0 Guest teaching 4.9 Guest disagreement 1.5 Ted pushing back 0.9
speaking balance: gold is Ted, purple is the guest (3 minute bins)
Sharpest disagreement ▶ 47:39 Charlie challenges Ted's skepticism on indexing
When Ted hints that indexing may not satisfy future institutional needs, Charlie immediately cuts in to demand where Ted could possibly disagree with the empirical case against active management.
Hardest push from Ted ▶ 47:45 Ted pushes back with the Yale endowment modelTed counters Charlie's universal indexing prescription by pointing out that top institutions like Yale hold virtually no public equities and rely on alternative asset classes.
Biggest teaching moment ▶ 40:20 The Bismarckian origin of retirement age 65Charlie delivers an extensive historical breakdown explaining how Chancellor Bismarck created age 65 retirement as a cost-effective way to remove sleepy train switchmen in 1880s Prussia.
Ted holds their own ▶ 30:16 Ted cites Asness and Arnott research on factor timingTed demonstrates deep domain expertise by contextualizing the academic debate between Cliff Asness and Rob Arnott regarding empirical limitations in factor timing.
the scores for every segment, with the reasoning behind each
| Chapter | Topic | Ted as informed peer | Guest teaching | Guest disagreement | Ted pushing back | Why |
|---|---|---|---|---|---|---|
| Early Wall Street Career and the Historic Money Game | 3 | 5 | 1 | 0 | Ted opens by asking Charlie about his thesis on indexing. Charlie delivers a detailed historical monologue about starting on Wall Street in the 1960s with the Rockefeller family and the individual-dominated 'money game.' | |
| Old Price Discovery Dynamics and Bank Trust Departments | 4 | 5 | 1 | 1 | Ted asks how price discovery functioned when 90% of trading was driven by retail investors. Charlie explains the trust department model and long-term holding strategies of that era. | |
| Institutional Market Shift and the Paradox of Skill | 4 | 6 | 2 | 0 | Charlie illustrates the total reversal to 99% computer/institutional trading and outlines the paradox of skill using a bridge analogy. Ted interjects briefly to complete Charlie's thought. | |
| Regulation FD and Massive Growth of Market Research | 2 | 6 | 2 | 1 | Ted attempts to move into portfolio implementation, but Charlie politely redirects him to first cover changes in corporate access, Regulation FD, and the massive expansion of Wall Street research teams. | |
| Global Growth of Finance Professionals and Trading Volumes | 3 | 6 | 1 | 0 | Charlie details the global rise of CFA candidates, trading volume growth from millions to billions of shares, and the math of why active management fees require 25% outperformance. | |
| Active Management Cost Burdens and SPIVA Performance Data | 3 | 5 | 1 | 0 | Charlie cites SPIVA data demonstrating that 84% of active funds fail to beat their benchmarks over ten years, making indexing a near-guaranteed path to top-quartile performance. | |
| Index Selection Strategies and Asset Allocation Best Practices | 5 | 4 | 1 | 1 | Ted references Einstein to ask how investors should select and construct index portfolios. Charlie explains choices between total market, broad US benchmarks, and strategic tilts. | |
| Smart Beta Limitations and Risks of Factor Timing | 6 | 5 | 2 | 2 | Ted probes into smart beta and factor investing. Charlie critiques the marketing of smart beta, noting that commercial incentives push factors right after peak performance, leading to cyclical disappointment. | |
| Behavioral Edge of Simple and Boring Index Investing | 5 | 5 | 1 | 1 | Ted brings up the debate between Asness and Arnott on factor timing. Charlie argues that the primary edge of indexing is being 'boring,' which prevents behavioral mistakes and market timing errors. | |
| Sponsor Message: Ridgeline Modern Front to Back Platform | 0 | 0 | 0 | 0 | Sponsor message read by Ted for Ridgeline. Monologue / advertisement segment. | |
| The Historical Bismarckian Origins of Retirement Age 65 | 4 | 8 | 2 | 2 | Ted asks whether index returns alone can solve underfunded pension and retirement liabilities. Charlie presents a masterclass on the historical origins of retirement age 65 tracing back to Otto von Bismarck's German railroad policy. | |
| Strategic Solutions for Individual and National Retirement Security | 4 | 6 | 1 | 0 | Charlie outlines concrete policy and personal financial steps, emphasizing that delaying Social Security to age 70 increases payouts by 76% and enables 401(k) compounding. | |
| Institutional Alpha Generation and the Yale Endowment Model | 7 | 6 | 3 | 4 | Ted pushes back by citing the Yale endowment model and questioning if passive public investing suffices for top institutions. Charlie playfully challenges Ted before acknowledging David Swensen's structural competitive advantages. | |
| Private Equity Inflows and Escalating Asset Valuations | 6 | 5 | 2 | 2 | Ted queries how institutions should evaluate private equity given high fees and long lockups. Charlie explains that immense capital inflows have inflated entry multiples, compressing expected returns. | |
| Emerging Market Growth and Stock Indexing in China | 6 | 6 | 2 | 2 | Ted asks about allocating to China and emerging market indexes that are heavily concentrated in tech and banks. Charlie admits that because retail traders dominate China, active management may hold an edge over indexing there. | |
| The Threshold for Passive Investing to Impact Price Discovery | 5 | 5 | 2 | 2 | Ted raises the common concern regarding the market share threshold where passive indexing degrades price discovery. Charlie estimates 80-85% of active managers would need to leave the business before market efficiency breaks down. | |
| Practical Career Advice for Aspiring Young Investment Professionals | 5 | 5 | 2 | 1 | Ted asks for advice for young investment professionals entering a crowded industry. Charlie cautions against chasing high compensation and recommends practicing servant leadership in mid-sized organizations. | |
| Investment Industry Pet Peeves and Passive Terminology Flaws | 5 | 6 | 3 | 1 | Ted starts closing questions asking about pet peeves. Charlie expresses frustration with commercialized active management and attacks the label 'passive investing' as an inaccurate and pejorative engineering borrowing. | |
| Parental Influence and Enduring Optimism in American Society | 4 | 4 | 1 | 0 | Ted asks about parenting teachings, skydiving experiences, and biggest investment mistakes. Charlie shares his long-term faith in America and his regret in not buying more Berkshire Hathaway after meeting Sandy Gottesman. | |
| Lessons on Market Cycles and Branding from Art History | 4 | 5 | 1 | 0 | Ted asks about unusual reading material. Charlie explains how art history and Canada's Group of Seven illustrate market cycles, collective branding, and shifting investor tastes. | |
| Podcast Conclusion and Monthly Curated Newsletter Announcement | 0 | 0 | 0 | 0 | Podcast outro and newsletter sign-up read by Ted. Monologue / housekeeping segment. |
Statements from this episode (41)
Institutions accounted for at most 10% of stock trading in the 1960s
“10% of trading at most was done by institutions.”
Successful active investing requires exploiting uninformed 'habitual losers'
“And the secret to successful active investing is to have what's called, it's a little bit nasty term, but called willing losers or serial losers or repetitive losers or habitual losers.”
Historical bank trust departments relied on small teams and approved-stock lists
“Cleveland Trust, for an example, would have half a dozen analysts who were willing to spend time covering utilities or industrials or financials. And a nine-thirty to four-forty-five day job, and they were reporting to a group of guys in their sixties who had …”
Computers drive 99% of combined cash and derivatives market trading volume
“That is, 99% of trading is done by computers in the cash market and derivatives markets added together.”
Equal access to advanced tools makes professional investors increasingly hard to beat
“Even though they're getting better and better, they're getting less and less different. And as they get less and less different, it's hard to beat the other guy.”
SEC disclosure rules eliminated active managers' private edge with company management
“First of all, the SEC now requires any publicly owned company that gives any useful information to any investor must simultaneously make a diligent effort to be sure everybody gets that same information. So no more private conversations with management.”
Active investment professionals grew from under 5,000 to over one million
“The second thing is the number of people involved in active investment management, best I can tell, has gone from less than 5000 to more than one million. Over 5060 years.”
Goldman Sachs did not distribute research notes to clients until 1964
“In fact, Goldman Sachs didn't start sending things out until 64 or five, and that was just one of the salesmen thought it might be an interesting idea to put Four sides of sheet of paper. Little information on four different possible investments. He was doing …”
Ellis: 135,000 people have passed CFA exams with 250,000 in the queue
“135,000 people have passed the exams, and another 250,000 people in the queue.”
Investment management is the highest-paid accessible career in modern history
“Well, first of all, the investment world is probably the highest paid line of work that's wide open to everybody there's ever been. Certainly the highest paid line of work today for large numbers of people.”
NYSE daily trading volume rose from 3 million shares to over 4 billion
“Trading back in the early sixties might be three million shares a day on the New York Stock Exchange. And today it's, I think it probably somewhere between four and five billion.”
Active managers must outperform by 25% just to match index returns
“Add that up, that's somewhere around two percent has to be recovered just to keep up with the market. So two percent of eight percent is 25%. You have to beat the competition by 25%, and they know everything you know as soon as you know it, and you can only bu…”
SPIVA data shows 84% of active funds underperform over ten years
“Take SPIVA is now putting out the data. Take the funds that were in existence 10 years ago and bring all of them forward, including the ones that were merged out or terminated. What fraction of them could not keep up with the index that they chose as their ben…”
Choosing index funds guarantees top-quartile performance over the long run
“If you would like to be sure that you're a top quartile manager chooser, all you have to do is choose index funds, and the chances are you'll be the top half of the top quartile. We're sure to be in the top quartile. Long run.”
Factor investment sales peak at market tops, leading to inevitable disappointment
“So if value has been working very, very well, the demand for interest in buying into, and the supply, i.e. The interest in selling people on, value factor investment will rise to a crescendo at the top, and then people get disappointed.”
Crowding will significantly reduce future profits for factor investing specialists
“I believe that the guys who have for years specialized in factor investing are going to find they can't make as good a profit from doing it as they used to because of the crowd, but they'll still probably do a pretty good job for themselves and for their inves…”
Investors using smart beta to beat the market will end up disappointed
“Those who are in it because it's a good commercial opportunity, Intermediaries or in it because they think, Hey, this is a new way to beat the market are going to create a self disappointing experience.”
Investors benefit by doing less because most portfolio adjustments are mistakes
“And the less you do, the more you benefit is the reality about investing. Because usually what you do is you make mistakes.”
Missing the best 2% of trading days erases 50-year market returns
“Over the last 50 years, if you missed two percent of the best trading days, you missed the whole 50 years.”
Underfunded public pensions will miss 7% returns due to heavy bond allocations
“You can see it easily in the state and city funds that are seriously underfunded, even if they're assuming a seven, seven and a half percent rate of return, which they're not going to get, because they've got 25% in two and a half, three percent bonds. They're…”
Half of US private-sector workers have no retirement plan outside Social Security
“The same thing, if you look at individuals, we've got half the population does not have a retirement plan. Private sector. They've got Social Security, but no retirement plan.”
Misunderstanding retirement savings will cause severe societal and political turmoil
“And I think we're going to have a terrible societal problem, political problem, if we don't recognize that we've got a Deep misunderstanding on retirement.”
Over 65% of lifetime health spending occurs in the last six months
“Something over 65% of your lifetime health expenses are spent in your last six months.”
Half of personal bankruptcies stem from end-of-life healthcare costs
“Well, people, that's where half the bankrupt, personal bankruptcies come from.”
Delaying Social Security to age 70 increases lifetime benefits by 76%
“It's actually 76% higher. Every day, for the rest of your life, inflation-protected, Benefits, Social Security, if you wait.”
Working through one's sixties can easily double or triple a 401(k)
“Take those three factors, not taking money out, keep it, put adding more money in rate of return. You easily double your four one K, maybe triple it.”
The Yale endowment holds almost zero public equities or bonds
“So our beloved alma mater, Yale University, has next to no money in public equities or bonds.”
Ellis holds only two investments: index funds and Berkshire Hathaway stock
“What do you do with your own investing? Oh, I've got two kinds of investment. One is index funds, which I'm so happy with, just really comfortable with. And the second is an index fund equivalent in many ways, Berkshire Hathaway.”
Non-index investing only works with an exceptional and largely uncopied edge
“I'm talking about if you are really an exception in the way you invest, you don't have to index. You can do something that's really different, but you have to be really good at your exceptional way of doing things, and you have to be not very widely followed o…”
The real competition in private markets is among allocators, not fund managers
“The real competition today is not by the investment managers to get your investment money. It's by the people who've got money to get access to the best investment managers. And that's been true for the last decade in venture capital. It's now clearly true in …”
Rising entry prices are compressing future private equity returns
“Entry price for private equity has been going up and up and up. The exit price can't keep going up a lot if some stock markets on the relatively high side ought to recognize that that's probably as good as we can anticipate. Jeepers. It's getting harder and ha…”
China's upper-middle class population exceeds the total US population
“Third thing is the middle class or upper middle class in China is larger than the U.S. Population.”
Index funds in China risk blindly tracking irrational retail speculation
“The Chinese market, as anybody who spends any time with it knows, is still dominated by retail investors, prices particularly. So unless you're good at understanding retail investors and how they track past price performance and project future price performanc…”
Index funds represent a small fraction of daily market trading activity
“First, if you have 30% of the value of the market indexed, That's not 30% of the trading activity. It's a much smaller fraction.”
Over 80% of active managers must quit before market price discovery breaks
“And I don't know what it would be, but it's certainly more than half the people would have to quit. Probably more than three quarters would have to quit. And my own guess would be somewhere around 80, 85% would have to quit just because it doesn't make sense a…”
Career choices should follow daily enjoyment of work rather than passion
“When young people say, I want to go with my passion, it bothers me because passion to me is an irrational, powerful emotion, and I'm not sure if passion is the right thing
To guide somebody.
But if you said, no, I really enjoy the nature of the work, and I'm r…”
Investment management compensation will decline as the industry's golden era ends
“Are you going to it because you think it pays so very well?
Be prepared.
It's not going to pay so much.
If you think you're going to it because it's fun, everybody's having a great good time, candidly be careful because the party may be
Closing down, and maybe…”
The term 'passive' unfairly biases investors against sensible index strategies
“Passive is a negative word. We're all taught to be active. Take charge. Do something. And it's a shame that nominal terminology has put an enormous negative effect Right on top of a very sensible way of doing it.”
Greenwich Associates bought Berkshire Hathaway in the 1970s and gained 300x
“So as a defensive move, we bought some Berkshire Hathaway. And candidly, it's worked out beautifully. But what I wish has gone up 300 times from where we bought it. What I wish, obviously, is we bought more. That's probably the biggest mistake I've ever made.”
Most of the greatest 1920s artists are completely forgotten today
“If you look who were the great, absolute sure, greatest artists in the 19 twenties, most of them nobody has ever heard of.”
Successful artists historically thrived through peer networks and collective marketing
“It turns out that artists who were successful, usually knew artists who were successful, and they learned a lot from each other in their art, but they also helped each other get sales, and in Canada, the Group of Seven organized themselves to see if they could…”