Wry & Dry

Happy 40th birthday to ...

W&D often wonders about kids these days.  "Hey, Dad, what computer games did you play when you were growing up?"


Well, likewise some investors seems to think that passive or index investing has been around, well, forever.

Nuh.  It was forty years ago this week that the world's first index or passive fund was born.  The Vanguard Group's First Index Investment Trust (today Vanguard 500 Index Fund) opened for business with $11.3m in assets.

Today that fund holds $252 billion in assets, with the industry, including exchange traded funds, having almost $5 trillion in assets globally.

Hang on.  What is an index fund? W&D hears some readers ask.

Well, stock market investors have, essentially, two choices.  

Firstly, active management, that is investing and trading with the aim of out-performing a sensible objective.

Secondly, passive management, where the objective is to match the performance of a market index.

Until 1976 active management was the way to go.  In fact it was the only way to go.  The reasons were three-fold: brokerage rates were often 3% or more, so brokers encouraged 'churning'; there was virtually no accurate and timely performance information available as there just wasn't the computer availability; and insiders had a massive information advantage.

Hence the phrase "Where are the customers' yachts?"*  That is stock brokers and money managers made a killing at the expense of the customer, who didn't know he/ she was getting ripped off.

Then along came index investing.  But it was greeted with acclamation.  The idea of indiscriminately buying hundreds of stocks, then accepting whatever return the market provided seemed a bit of a joke at first.

Aside from the impracticality of building such a fund in the infancy of computers, an index fund was an insult to investors who prided themselves on picking the best stocks out of thousands.

But there was theory behind the idea.  Simply: someone discovered that most active investors failed. 

In 1960, two University of Chicago graduate students published an article in Financial Analysts Journal calling for an “unmanaged investment company.” “Investment companies as a whole have not outperformed representative stock averages,” Edward Renshaw and Paul Feldstein wrote, so why not offer a portfolio that automatically buys every stock in the Dow Jones Industrial Average or some other index?

The trouble was, of course, that there was not the computers to speedily administer the changing weights of stocks within an index. 

So it wasn't until (a) the computer power was available and (b) someone (a John Bogle) had the drive and guts to figure out how to build, administer and market the product that the theory turned into practice.

But critics called the new idea 'un-American' and there was much laughter on Wall Street.  But Bogle, who formed Vanguard, was sure that the retail market would like a cheap fund that would neither out-perform nor under-perform an index.


He was right.

After a very slow start (commencing any investment vehicle in the 1970s was difficult because of the oil shock) the index fund began to boom.  Especially with the epic bull run that lasted from 1982 to March 2000.

Today, that firm, Vanguard Group, is the largest managed fund company in the world, with $3.6 trillion in a variety of index funds.

Of course, indexed investing does have its drawbacks.

Firstly, by definition, an index fund will always under-perform its index by the level of its fees.

Secondly, an index fund will hold the most weight in a stock at its greatest valuation, and hence be most vulnerable to its correction.

Thirdly, index funds that replicate an index (rather than duplicate) by using derivatives or algorithms are most vulnerable in times of high volatility or scarce liquidity.

The takeaway?  If you cannot find an active manager that adds value over the long term, then appoint an index manager.

And happy birthday, Vanguard.

*Which was the title of one of the most amusing and penetrating views of Wall Street ever written. Written by Fred Schwed in 1940, it's a very cynical look at Wall Street.