Winning the loser’s game

I don’t really follow tennis, but it turns out that an insulting label for tennis players connects to a very important investment idea.

A recent Wall Street Journal article (subscription required) about British tennis professional Andy Murray focused on the term “pusher,” which reporter Hannah Karp wrote “implies a player who refrains from trying to hit winning shots and is content to return the ball with partial strength in hopes of getting the opponent to make unforced errors.”

The investment connection to “pusher” is an article published 35 summers ago in The Financial Analysts Journal by investment strategist Charles D. Ellis. That article—“The Loser’s Game” (expanded later into a classic book, “Winning the Loser’s Game”)—contributed to Vanguard’s launch in 1976 of the first indexed mutual fund. Vanguard founder Jack Bogle credits the Ellis article as a key influence on his decision to create what is now Vanguard 500 Index Fund. The article also influenced the broader world of money management.

Mr. Ellis (who served on Vanguard’s Board of Directors from 2001 through 2009) wrote that investment management “has become a loser’s game.” He likened investing to tennis, a game where most victories are achieved not by making spectacular winning shots, but instead by making fewer errors than the opponent. If you consistently get the ball across the net and in the court, eventually your opponent will hit the ball into the net or outside the lines. And as this tactic frustrates opponents, they’re apt to take more risks to hit a stunning winner, leading to yet more unforced errors.

The parallel, Mr. Ellis wrote, was that investing had become dominated by highly skilled professional money managers (the dominance is even greater today than in 1975). Because their transactions made up the vast majority of market activity, the professionals as a group had to earn pretty much the market return.

But these professionally managed pools have costs: compensation for skilled analysts, traders, and portfolio managers; transaction costs such as commissions and bid-ask spreads in the securities markets; and operating costs such as fees for custodial services, accounting, and so on.

To outperform the market averages after these costs, he reckoned, an investment manager had to be able to outperform the other skilled pros by a significant margin. And he asked: “But how can institutional investors hope to outperform the market by such a magnitude when in effect, they are the market today?”

His view of money managers’ belief they could outperform the market? “They won’t and they can’t.”

And, indeed, over the past 35 years investment managers as a group have continued to lag behind the market benchmarks they’re trying to beat. That fact is why Vanguard believes strongly in index investing.

As Mr. Ellis put it in that seminal article, “if you can’t beat the market, you certainly should consider joining it.”

Index funds, he wrote, were one answer. But he also suggested that actively managed portfolios stood a better chance of winning the loser’s game by consistently following a disciplined investment strategy, keeping portfolio turnover low to minimize costs, and focusing on defense to manage risks.

If indexing “wins” over the long run by minimizing operating and transaction costs, you’d expect lower-cost actively managed portfolios to stand a better chance of winning the loser’s game. And a bunch of independent studies, including by fund analysts at Morningstar, have borne out the notion that low expense ratios, not past performance, are a key factor to consider in the search for actively managed funds.

A low-cost, disciplined investment approach will rarely, if ever, result in the highest or the lowest investment returns in a particular period, because the top and bottom results are likely to be dominated by funds taking more risk. The tennis analogy again might be apt: Mr. Murray, though he’s never won one of the top “Grand Slam” events in tennis, has clearly been successful with his approach. And he’s far, far removed from the bottom of the rankings.