Trillions: a new history of the rise and rise of passive investment
A new book by Financial Times journalist Robin Wigglesworth surveys the history of index funds and considers their increasingly significant implications for the global economy.
There are plenty of academic papers and specialist investment books setting out the theory behind passive investment, and innumerable articles scattered across the business press telling the story of the rise of index fund giants like Vanguard and BlackRock.
But Trillions, by Financial Times journalist Robin Wigglesworth, pulls the strands together into a coherent narrative, offering both an accessible history of how index funds evolved and thoughtful reflections on their increasingly significant implications for the global economy and the financial security of ordinary people, whether regular investors or pension holders.
On first acquaintance the concept seems rather underwhelming. A passive fund is a basket of stocks that simply tracks an index, such as a stock exchange or a market sector, rather than trying to outperform it. But the hard evidence is that over the longer term, perhaps five years, and certainly a decade, index funds secure higher returns than actively managed funds, and for significantly lower fees, making them ideal holdings for both institutional investors like pension funds, and private shareholders seeking reliable returns without having to take a chance on the selection of individual stocks. Wigglesworth estimates that since their stuttering introduction in the 1970s index funds have accumulated holdings worth more than $25 trillion.
The Chicago School
The book opens with a story that has come to encapsulate the case for passive investment, the 2007 wager between legendary investor Warren Buffet and hedge fund manager Ted Seides pitting the 10 year performance of a cheap S&P 500 tracker against that of a fund compiled of five top hedge funds. The result was emphatic, Buffet’s chosen tracker, the Vanguard 500 Index Fund available to any retail investor, returning 125.8% over the period against 36.3% for the fund-of-hedge-funds. The margin was all the more remarkable for the fact that the decade encompassed the financial crash and its aftermath, turbulent conditions in which hedge funds, able to both buy and sell stocks under the oversight of the industry’s self-styled elite, should have been at an advantage against a humble tracker obliged to go with the flow of the market.
The first two-thirds of the book offer a fast paced history of the intellectual genesis of passive investment theory and the subsequent struggle of its early converts within the finance industry, who Wigglesworth considers ‘some of the most consequential if under-appreciated disruptors of the modern era’, to develop the technologies and methodologies necessary to implement the first index funds, and, more challenging still, to overcome the stubborn hostility of their professional peers and initial indifference of both institutional and private investors.
Passive investment theory evolved through the 1950s and 60s as economists and far-sighted industry insiders attempted to establish systematic principles for the process of stock selection. Although Benjamin Graham had begun elaborating a rigorous intellectual framework for value investing before the war, for the most part investment was seen as something of a dark art practised by star fund managers believed to have preternatural insight into the stocks most likely to rise.
Wigglesworth briskly summarises the essential thought of the cluster of academics associated with the University of Chicago who built modern portfolio theory, notably Harry Markowitz, William Sharpe and Eugene Fama. Markowitz’s seminal 1952 paper Portfolio Selection laid the foundation stone, introducing the now universally accepted principle of diversification according to which securities should be selected according to how they work together within a portfolio rather than on their individual merits, optimising the likelihood that if one falls another will rise in compensation.
Sharpe elaborated Markowitz’s insight, showing that, in theory, the optimal diversification strategy should simply track the global market. According to Sharpe’s inexorable logic, neatly summarised by Wigglesworth, longer term investment returns are governed by ‘two iron rules’: ‘The return on the average actively managed dollar will equal that of a dollar managed passively before costs, and after costs the return on that actively managed dollar will be less than that of a passively managed dollar. In other words, mathematically the market represents the average returns, and for every investor who outperforms the market someone must do worse.’ Because index funds charge less than active funds, therefore, the average passive investor must do better than the average active one.
Fama proposed the still more radical ‘Efficient Market Hypothesis’ (EMH), which reasoned that in an efficient market where information is readily available to all market participants, every security is always accurately priced, reflecting expectations of future value. In such a market, subject to forensic scrutiny by legions of analysts, stock prices are constantly recalibrated to reflect expectations of their future value, making it impossible to identify securities that have been mispriced. Investors should therefore be content to track rather than try to beat the market. The EMH was controversial then and is controversial now. As even casual observers know the market is an emotional place, subject to wild swings in sentiment. And a good many smaller stocks, particularly those in emerging markets, are still widely researched, and may indeed be misvalued. But though the hypothesis can only offer a stylised picture of how markets work, it is generally accepted that markets are indeed effectively efficient over the longer term, explaining why they are so hard to beat on a consistent basis.
In addition to laying the theoretical groundwork for passive investment theory Chicago economists developed technologies for accurately indexing markets, helping to create the metrics tracker funds rely on. And the university played an important role in bringing the new theories to the attention of the wider industry, its Center for Research in Security Prices, better known as CRSP, organising the now celebrated series of seminars attended by many who went on to pioneer the first tracker funds.
The first index funds
Given the scepticism of the emerging passive investment movement regarding the ability of professional asset managers to pick winning stocks it’s hardly surprising that the first index funds were pioneered by those on the industry’s fringes. As an executive at one mainstream investment fund put it: ‘I can’t believe that the great mass of investors are going to be satisfied with just receiving average returns. The name of the game is to be the best.’
The first significant passive products were engineered on the West Coast rather than Wall Street, at the venerable Californian bank Wells Fargo where a far-sighted board gave industry newcomer John McQuown the funding necessary to establish a Management Sciences division which, with access to IBM mainframe computing power, and a superstar cast of economists including Markowitz, Sharpe, Fischer Black and Myron Scholes, was able to dedicate considerable resources to exploring possibilities for index funds.
Even so, the team initially hedged their bets, early Wells Fargo funds tracking low-beta and equal-weighted S&P 500 stocks rather than simply mirroring the exchange. The first ‘pure’ index fund, the Wells Fargo Index Fund for Employee Benefit Trusts, which weighted each security according to its overall stock market value in accordance with passive theory, did not appear until 1973. But the timing proved fortuitous, coinciding with the advent of a bear market during which active funds performed poorly, and increasing evidence of the indifferent performance of many high-charging funds, one major study finding that some four-fifths had trailed behind the S&P 500 in the decade to 1975. Influential publications by luminaries such as Paul Samuelson and Charles Ellis arguing that investment management had become a ‘loser’s game’, and Burton Malkiel’s 1973 best selling introduction to passive investment, A Random Walk Down Wall Street, were helping to shift the dial of opinion within an increasingly receptive industry. By 1977 the first few index funds were already holding nearly $3 billion of pension fund money, soaring to $91 billion by 1985
Wigglesworth offers an entertaining blow-by-blow account of the development of the first index fund for retail investors, the Vanguard First Index Investment Trust, launched in 1976 thanks to the efforts of a cast of out-sized characters including CEO Jack Bogle. It too had a uncertain start, failing to raise enough on IPO to buy the full S&P 500 index, but went on to enjoy a rocket fuelled ride through the 1980s, propelled by the growth of 401(k) retirement plans, increasing investor awareness of passive theories, and the clear run the company was given by the Depression-era Glass-Steagall Act, which prevented banks that would have otherwise competed with Vanguard from selling products to ordinary investors.
But Bogle’s conviction that index funds were designed to be bought and held ‘forever’ rather than traded through the day like other securities, meant the company was relatively slow to take advantage of the next big development in the passive investment world, the advent of Exchange Traded Funds (ETFs). During a fateful meeting between Bogle and another of the book’s most intriguing characters, Nate West, then working out the fundamentals of ETF technology, the Vanguard CEO passed up the offer to sponsor its development, fearing tradable products would muddy his clear messaging regarding the nature and purpose of index funds.
Most drew on his experience of observing traders in Pacific in the course of his long career — he was already in his 70s at this point — to conceive the ‘warehousing’ concept on which ETFs are based. Recalling how the merchants he had encountered bought and sold receipts of commodities, rather than physical vats of coconut oil, barrels of crude, or gold ingots, he suggested ETFs should be conceived as virtual warehouses in which securities are deposited. Nate led the development of an elegant creation/redemption process according to which ‘investors can either trade shares of the warehouse between themselves, or go to the warehouse and exchange their shares in it for a slice of the stocks it holds. Or they can turn up at the warehouse with a suitable bundle of stocks and exchange them for shares in the warehouse.’
The framework was to prove spectacularly successful. By 2013, State Street’s very first ETF tracking the S&P 500 index, launched 20 years earlier, was the most heavily traded stock in the world. But like Vanguard State Street was not able to capitalise on its pioneering work to become the leading ETF provider. Other companies were quick to use the warehousing framework to package ever wider range of securities, notably Barclays Global Investors (BGI) — the product of a merger between the banking giant and the Wells Fargo offshoot that developed the very first index funds — which rolled out the iShares range of ETFs.
One of the book’s most compelling chapters narrates BGI’s £13.5 billion 2009 acquisition by BlackRock, a calculated gamble that was to transform an already fiercely competitive asset manager into a Wall Street giant: by the end of 2020 the iShares unit managed $2.7 trillion, taking BlackRock’s stock market value beyond that of even Goldman Sachs. iShares is just the most spectacular manifestation of the runaway success of the ETF juggernaut. In 2000 there were 88 ETFs holding $20 billion of assets; 20 years later there were nearly 7,000, holding $7.7 trillion.
The book’s concluding chapters zoom out from storytelling mode to consider the impact of the ongoing passive revolution. Wigglesworth is a fan. Although passive products have earned billions for the owners of the leading index funds, the bigger picture shows they have done much to spread the financial sector’s wealth to ordinary investors. Competition from low cost index funds — the Vanguard tracker Buffet purchased cost just 0.04% a year — has forced active managers to significantly reduce their fees, which used to include the notorious ‘load’, an upfront sales charge that would take a cut of 5 to 10% of the initial money invested, annual fees of around 2%, and, very often, performance fees taking a slice of the profits generated. Since the advent of ETFs mutual fund fees have halved. BlackRock CEO Larry Fink plausibly suggests that, love them or hate them, the big index providers are shaking up the finance sector much as Amazon have transformed retail, giving consumers what they want: lower costs, transparency and convenience.
Though the most radical versions of the EMH continue to be fiercely disputed, the facts still don’t lie. Wigglesworth notes that as of June 2020 only 15% of US investors had managed to beat their benchmark over the previous 10 years. Although there are outstanding fund managers it is difficult to pick them out: less than 3% of the top performing equity funds retain their position for more than five years.
Defenders of active funds argue that the relentless growth of passive funds is warping the market’s capacity to allocate capital effectively, with more and more money pouring blindly into index funds parasitical on the investment decisions made by active managers. Tesla’s shares, for example, soared by 70% in November 2020, not because of any spectacular progress made by the company, but simply because the stock’s was included in the S&P 500.
For Wigglesworth this concern is somewhat over-played. Around 85% of US stock market holdings are still actively managed, and more shares are being traded than ever before, the market’s money making opportunities, and the growing ease with which shares can be traded, continuing to attract new fund management start-ups and an ever growing number of retail investors. ‘One can see parallels between the birth and growth of index funds in financial markets and the introduction of an alien animal into a natural ecosystem that then creates havoc,’ he suggests. ‘Financial markets have always been a dynamic ecosystem, which eventually adapts to the emergence of new beasts in the jungle, whether it was the investment trusts of the nineteenth century, the birth of mutual funds in the twentieth century, or more recently the emergence of hedge funds.’
There’s no doubt though, that with so many trillions flowing into passive products, ever more power is being concentrated in a handful of index fund giants and the institutions that regulate the indices they track. Passive funds have a snowballing effect, their fees falling as they grow, attracting ever more investors. Wigglesworth notes that since 2010 around 80 cents of every dollar invested in US markets has been plugged into funds overseen by the Big Three providers, Vanguard, State Street, and BlackRock, which now have a combined stake in S&P 500 companies of more than 20%.
And with so much money flowing into them, those who regulate the S&P Dow Jones, MSCI, and FTSE Russell and other major indices also wield extraordinary power, able to inflate the value of companies falling within their benchmarks — as illustrated by the example of Tesla — and even influence the direction of national economies. Five years ago MSCI considered moving Peru from its emerging market index to its frontier benchmark, a downgrade that could have cost the country billions, the MSCI Frontier index tracking only $12 billion compared to the MSCI EM index’s $1.5 trillion. China’s 2018 upgrade to the EM indices supercharged the country’s continuing rise and ruffled political feathers in the US. Wigglesworth cites a striking paper by Harvard Law professor John Coates The Problem of Twelve, which suggests that power is being concentrated in ‘just a dozen or so people working inside the index fund giants, the proxy advisors, and a handful of traditional investment groups that will likely continue to thrive’.
Larry Fink’s 2020 annual letter to investee companies suggested BlackRock is aware of the pressure to exercise its power responsibly, asking each one to report on their sustainability progress ‘with the same rigour that it analyses traditional measures such as credit and liquidity risk.’ Whether any asset manager, however, even one with BlackRock’s resources, can monitor so many companies effectively, remains to be seen.
Another issue, of more immediate relevance for ordinary investors, is that the temptation presented by the wild proliferation of passive funds makes it easy to lose sight of the most basic passive investment principle, so sublimely simple that it can perhaps only been seen with some effort: the most reliable long term return is secured by buying a basic well-diversified tracker and holding it for decades.
Nate Most’s flexible ETF system opened the floodgates, allowing a multitude of indices to track relatively few companies. By one estimation there are now nearly three million indices — encompassing everything from uranium mining to more diverse board representation — measuring the performance of just over forty thousand public companies, of which only three to four thousand are tradable. With so many niche products available to tempt investors Wigglesworth suggests ‘there is in practice little meaningful difference between taking a bet on a hot dotcom stock and on a biotech or robotics ETF.’ Benchmark design involves highly subjective active choices, but made by anonymous index committees rather than star portfolio managers.
There are signs, perhaps, that the tendency to proliferation is beginning to exhaust itself, reaching its logical conclusion with the emergence of ‘direct indexing’ products that give investors total freedom to design their own index funds, allowing them to buy all the individual securities in an established benchmark and then simply strike off the companies they don’t want. Direct indexing technology promises to give investors the best of both worlds, letting them start with a mainstream index then remove remove just a few companies here and there, whether on ESG or other grounds.
The momentum of the passive investment tide is pushing the financial industry into uncharted waters. But Wigglesworth is surely right to conclude that, just now, ‘the benefits are real, and enormous’ for everyday investors saving for college fees, homes and retirement. His book plugs an important gap in popular economics literature, telling the story of seemingly esoteric financial innovations that have crept up on the world, with implications for us all.