9/20/2011 5:15 PM ET|
Investing's $2.3 trillion revolution
When passive investing was first introduced, it was met with derision. But as the concept has proved its value, index funds have blossomed and evolved in new directions.
A revolution of sorts started 35 years ago, on Aug. 31, 1976, when John C. Bogle launched the Vanguard 500 Index Investor (VFINX), a mutual fund that holds all the stocks in the Standard & Poor's 500 Index ($INX).
It was the first fund to let individual investors own the broad stock market rather than actively trying to beat it.
"It was a seminal event in investing," says Dan Culloton, associate director for fund analysis at Morningstar. "It introduced passive investing to retail investors and eventually started a slow and steady revolution that continues today."
In truth, that revolution started in the 1960s with the efficient-market hypothesis championed by economists Eugene Fama and Paul Samuelson and popularized by Burton Malkiel in his 1973 book, "A Random Walk Down Wall Street." That theory, which holds that stocks are rationally priced, provided the philosophical underpinnings for simply buying and holding the entire basket of publicly available stocks.
It took a while for the idea of investing in indexes to catch on. Starting in the late 1960s, William Fouse, known as the "father of indexing," and John McQuown worked at Wells Fargo to develop an index fund for large institutions. In the early 1970s, Dean LeBaron and Jeremy Grantham at Batterymarch Financial Management also pursued index investing. But Bogle's mutual fund opened the concept to the general public and focused on providing a low fee structure to prevent returns from being eaten away.
Investors didn't exactly rush to buy Bogle's fund when it became available. It opened with $11.4 million in assets ($43 million in today's dollars), well short of Bogle's goal of $150 million. Other money managers were dismissive, if not hostile. Bogle, who founded Vanguard Group in 1974, has said he heard the fund derided as Bogle's Folly "all too often from the late 1970s through the early 1990s." Others reportedly called it un-American.
"Some of the early critics of index funds said you're not trying to identify the best-performing stocks, you are aiming deliberately for mediocrity," says Robert Arnott, a former editor of The Financial Analysts Journal and the founder of Research Affiliates, an investment management firm that offers its own twist on traditional index funds. Adds Arnott: "Jack Bogle very sensibly said, 'You know, you're absolutely right, we're aiming for mediocrity -- unfortunately, that's better than most active managers.'"
Active money managers, more often than not, fail to beat the market, and many investors may not appreciate the extent to which management fees paid to those active managers wind up eroding their returns.
"There's a very strong argument that just getting the market rate of return is actually a very attractive proposition for investors," says Vanguard Chief Investment Officer Gus Sauter. "After costs, the average investor no longer gets the market rate of return; they get the market minus costs. And the marginal outperformers become underperformers after costs. A majority of investors will underperform the market rate of return because of that."
As index funds have shown their value, investors have increasingly shifted money into them. The Vanguard 500 Index Fund reached $1 billion in assets in 1987, 11 years after its launch, and ballooned from there to become the world's largest mutual fund for a time.
"The big growth really happened starting about 1995 and on for the next five years, when really large-cap stocks outperformed quite dramatically and the S&P 500 performed extraordinarily well," says Sauter.
The fund now has $105 billion in assets. Overall, Vanguard manages about $1.7 trillion in assets, with 55% of that in passive index funds.
Index funds boomed well beyond Vanguard. More than 360 index-based stock and bond mutual funds were available to investors as of last year, and assets in those types of funds have swelled from $27 billion in 1993 to more than $1.4 trillion as of June, according to the Investment Company Institute.
Exchange-traded funds, which track an index but are traded like stocks, have also proliferated and exploded in popularity, with nearly 1,000 now on the market.
In all, investors have poured $2.3 trillion into passive funds and ETFs, according to Morningstar. That's still far behind the $7.2 trillion in actively managed funds. But index funds are growing faster and attracting more money than actively managed funds. For the 12 months ending in July, $189 billion flowed into passively managed funds and ETFs, compared with $105 billion for their actively managed counterparts.
Money-management companies have taken indexing in a host of directions, challenging the original idea of owning the broad market. The indexing movement has been splintered into scores of smaller offerings, with mutual funds and, in particular, ETFs that slice and dice the investable universe into narrow bits.
"People are really just throwing anything at the wall to see what is going to stick," says Morningstar's Culloton.
Companies such as Arnott's Research Affiliates and Wisdom Tree now offer funds based on "fundamentally weighted indexes," which use factors other than traditional market capitalization to determine the balance of their holdings.
Bogle and others in his camp insist those new variations aren't indexing -- that by using factors other than market capitalization, the new funds don't aim to simply replicate the market but instead are making more active bets in an attempt to produce outsize returns.
The lasting legacy of the first index mutual fund has yet to be determined, but it's clear that index funds are here to stay. "It was a brilliant idea," says Arnott. "It's an idea that has stood the test of time."
This article was reported by Yuval Rosenberg for The Fiscal Times.
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Quite well, actually. I switched from a managed large cap value fund to an S&P 500 index fund which has outperformed the fund from which I switched. In the process, I saved nearly 3/4 of a point in expenses, and as I stated, have outperformed it's managed counterpart. The Vanguard fund also has a higher dividend rate, further increasing its attractiveness.
You're one of those guys that only looks at the index and not the reinvestment of dividends, eh?
Of course, in an era in which the markets are dominated by speculators, fast traders, and the Wall Street Geese, the underlying premise that stocks are rationally priced is probably a crock. It's just a casino, and one that's being manipulated in a way that does the buy-and-hold investor no good.
Index funds are a marketing gimmick. They are poor over the long term. Think about it - they rise as the market goes up and fall as the market inevitably comes back down. You almost never get any capital gains because they keep going up & down like a yoyo. The gains are never locked in because they don't sell. And, in fact, on the rare occasions that they do, index funds tend to buy high & sell low - ex. when a stock in the S&P500 index tanks (such as AIG), the folks that manage the index have to remove that stock and replace it with another - so what do they do - sell the stock in the index usually at a loss because it's low, and replace it by buying another stock usually at a high valuation. This is a bad recipe.
Index funds are usually rationalized by their low cost. Remember, you usually get what you pay for. McDonald's food is relatively low cost but would you rather have a Big Mac or dinner at The Four Seasons?
If index funds really are the best way to invest, then how do you explain the existence of traders and professional money managers?
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