The Globe and Mail, Report on Business
Published December 12, 2009

John Bogle starts his latest book, Enough, with a great story. Kurt Vonnegut and Joseph Heller were at a party hosted by a hedge fund manager. Mr. Vonnegut muses that their host makes more money in a day than Mr. Heller earned from his wildly successful novel Catch 22. As the story goes, Mr. Heller responded, "Yes, but I have something he will never have...enough."

Mr. Bogle, who is the conscience of the wealth management industry, covers a broad range of topics in the book. Early on he exposes the excesses and wrong-thinking of the investment industry - high fees, too much turnover and complicated products. His antidote to these ills is low-cost indexing, which is to be expected from the founding father of indexing and the trillion-dollar mutual fund company, Vanguard, that made it mainstream.

As I read the book, however, I couldn't help but think that the industry's flaws not only enhance the appeal of indexing, they also set the table for active managers to succeed (i.e. generate returns in excess of the market indexes). Where there is excess, there is opportunity. If the industry truly is off kilter as Mr. Bogle says, then there has to be some low-hanging fruit that active managers can pick.

Using his three major complaints as a framework, let's assess where the opportunities are for active managers.

Too much cost, not enough value

Active managers will always be at a fee disadvantage compared with indexers, so there is limited opportunity here. But the gap doesn't need to be so wide if the fees charged are reasonable and there is a tight rein on other costs, including trading.

A premium fee may be justified if the services provided lead to better and/or smoother returns for the client. Index funds are predictable in how they track the market averages, but they tend to be more volatile and prone to excess than actively managed funds. We saw that in 2000 when indexers owned more technology than all but a few managers.

Trading is an area where active managers can have a cost advantage. Indexers are users of liquidity. Their buying is indiscriminate - it's more important to get the transaction done than to worry about the price. Some active traders are similar in this regard, but there are others who are providers of liquidity. They are rewarded with better prices for being the supplier of last resort to those who urgently want to buy or sell. As a trader, it's always good to be on the other side of urgency.

Too much speculation, not enough investment

Mr. Bogle has been on this warpath for years, pointing out whenever he can that investors trade too often and have too short a time frame. He uses John Maynard Keynes' definitions to make his point. Investment is, "forecasting the prospective yield of an asset over its entire life." Speculation, on the other hand, "is the activity of forecasting the market."

Ironically, exchange-traded funds (ETFs), which are the best way to index in Canada, are increasingly being sold as timing vehicles. Advertising encourages investors to "take a view" and be a market timer or sector rotator. So even though index funds don't time the market, some indexers do.

In any case, short-term thinking is the most glaring and enduring inefficiency in the market and the one that presents the most opportunity. Managers that have strength and patience to take a longer-term view will be rewarded.

Too much complexity, not enough simplicity

At the end of the day, all investment products have the same underlying investments - stocks and bonds. Packaging and special features obscure that fact by putting layers of people, fees and risk between the client and their securities. As products get more bulky and complicated, active managers are presented with two opportunities to make excess returns. They can get back to the basics and beat the indexers at their own game. Or they can do their research and take advantage of the inefficiencies.

Keeping it simple means holding a manageable number of securities, limiting the number of people involved in the decision-making process and sticking to a logical and repeatable philosophy. It means minimizing the slippage between the fund manager's views and the portfolio's makeup.

Alternatively, managers can take advantage of the excesses. Hedge funds do this all the time, profiting from structured products that are poorly understood or sold to the wrong investors. Short sellers jump all over securities that have poor transparency and appear to be defying gravity. And bond managers that roll up their sleeves and figure out complicated debt instruments are rewarded with extra yield.

I won't argue with Mr. Bogle's solution to the industry's shortcomings. Indexing will do the trick, if it's done with the long term in mind. But high fees, rampant speculation and complexity also play into the hands of anti-indexers. The odds are stacked in favour of the few managers that don't charge too much, don't get sucked toward the index and don't make it too complicated. They can prey on a bloated industry that just can't say "enough."