Some good ideas take a long time to gain acceptance.
When Adam Smith argued forcefully against tariffs in his 1776 classic The Wealth of Nations, he was very much in the minority among thinkers and policy-makers. Today, the vast majority of economists agree with Smith and most countries officially support free trade.
Index investing, sometimes called “passive investing,” has taken somewhat less time to gain acceptance, growing from a cottage industry and intellectual sideshow in the 1970s to a major player in the world of finance today.
Indexing consists of picking a benchmark stock index — for example, the S&P 500 index (S&P500) of large capitalization US equities — and buying the components in order to replicate its performance. Thus, the manager of an index mutual fund is sometimes characterized as engaging in “passive investing,” buying the stocks in the index and keeping them in the fund roughly in accordance with their weight in the index, rather than trying to pick individual high-performing stocks, as an “active manager” might do.
The intellectual godfather of index investing is Burton Malkiel, a retired Princeton professor; its Johnny Appleseed is John Bogle, founder and former CEO of the Vanguard Group.
In 1975, Malkiel published A Random Walk Down Wall Street, now in its 12th edition. A Random Walk sets forth, in layman’s terms, the efficient markets view of finance: stock equity prices reflect the best currently available information about the underlying firms. Any attempt to forecast individual stock price movements and “outguess” the market is likely to fail. A better strategy for the equity portion of your portfolio is to buy shares in an index that encompasses a substantial portion of the market; however, stock market mutual funds in the 1970s did not offer such index mutual funds to their clients.
Around the same time that Malkiel’s Random Walk appeared, Bogle founded Vanguard Investments, and shortly thereafter established a stock market mutual fund that approximated the S&P500. Vanguard now has approximately $3.5 trillion under management and is one of the world’s largest investment companies.
Index investing makes good sense for a number of reasons. First, there is ample evidence that nobody, including mutual fund managers and publishers of stock market newsletters, is all that that good at beating market averages. And those that do beat the market in any given year will not necessarily do so again in a subsequent year.
Second, hiring professionals to pick stocks and paying commissions to trade shares increases the cost of managing a mutual fund, which cuts into investor returns. The average expense ratio of US equity mutual funds is somewhere between 0.66% and 1.03%; the average expense ratio at Vanguard is 0.19%. Although the differences in these figures might seem insignificant, assuming a 7% rate of return before expenses, at the end of 30 years an investor would be 11 to 15% wealthier having invested in a low-fee fund rather than a high-fee fund.
Third, actively managed funds can have negative tax consequences for investors because of high turnover. Whenever a fund manager sells shares at a profit, investors receive capital gains, on which they must pay taxes. By contrast, index funds have much lower turnover and hence generate fewer taxable capital gains for their investors.
Given all the advantages of index funds, it is perhaps not surprising that they have become more popular in recent years. Assets in S&P500 index mutual funds have grown by an average of more than 17% per year for the last 22 years; assets in all index mutual funds have increased by an astounding 22% per year during the same period. Among the high profile supporters of index funds is Berkshire Hathaway chairman Warren Buffett, who urged his executors to invest the vast majority of his estate in low cost index funds.
Although indexing has clearly been a boon to investors, it is possible that if the upward trend continues, it may have some undesirable economic consequences. If everyone indexes, the absence of “active investors” looking for mispricing in the market in order to turn a profit would render the market less useful in attracting funds to growing sectors and firms. Because index funds concentrate their funds in larger companies, more indexing may encourage the growth of large companies (at the expense of smaller ones) simply because they are already large. Finally, large index funds may increase the concentration of firm ownership, with problematic consequences for industrial competition, and put index fund managers in the uncomfortable position of taking a more active role in managing the firms in which they are “passive” shareholders.
Index investing has grown dramatically since the 1970s, and is likely to continue this impressive growth in the years to come. As indexing becomes an even more dominant investment strategy, policy makers will have to remain alert to its potential downside.
Featured image credit: NYSE, New York. by Kevin Hutchinson. CC-BY-2.0 via Flickr.