How Index Funds Stole Trillions from Wall Street
The best tribute to Vanguard founder John C. Bogle near the end of his long life cannot be repeated without heavy censorship. It was a quote in Financial Times journalist Robin Wigglesworth’s book,Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever, attributed to Gawker writer Hamilton Nolan. Nolan wrote, “Che Guevara looks good in a beret, and Eldridge Cleaver had his moments, but today let us all take a moment to honor Real Mother…ing Hero of the People: John mother…ing Bogle, who has kept hundreds of billions of dollars out of the pockets of Wall Street greedheads.”
How true this is can be illustrated by a greedhead niche that Bogle had only barely penetrated. Administrators of large public pension funds in the United States still award the management of their funds to high-fee active investment managers, including heavy allocations to hedge funds, private equity funds and other alternatives to standard stock and bond funds. On average, each public fund hires 182 investment managers. In aggregate, these managers underperformed an equivalent mix of total market stock and bond index funds over the last 12 years by more than one and a half percentage points a year. For this failure, they have charged fees that have cost the average U.S. taxpayer $500 each year – a total of $68 billion annually.
Had they invested in index funds instead, the fees would have been less than a hundredth as much.
A long history
It is a long and winding path Wigglesworth covers that led to index funds. They have only picked up speed in the current century.
I was present during some of the earlier part of that history. I have strong memories of the events and personalities and how I felt about it all. I even had some real involvement, in a way. With the reader’s forbearance, I will indulge myself and give a few anecdotes from that time.
Wigglesworth covers the development of the index fund at Wells Fargo Investment Advisors (WFIA) in the late 1960s. That was a little before my time. I came in shortly afterwards.
In 1971 I received a PhD in pure mathematics from Northwestern University. My doctoral dissertation was on a mathematical process called Brownian motion.
Pure mathematics bears no resemblance to reality, even to arithmetic. People find this hard to believe, but pure mathematics doesn’t use any numbers. My dissertation had no numbers in it, except for the symbols with special mathematical properties pi (ᴫ, with a value of 3.14159265…) and e (with a value of 2.71828…), and the occasional 0, 1, or 2 used as a subscript or superscript.
Although I was getting a PhD in a very academic field, I did not want to pursue a career in academia. I wanted the real world. I expected that by getting a PhD in mathematics, I would know mathematics better than the engineers and scientists I anticipated working with when I got a job.
But the Vietnam War was still raging and I had been prominent in the movement against it. All the technology and science companies I might have wanted to work for were producing anti-personnel weapons and the like for the war.
A guy in my probability class suggested I might want to look into a brokerage company in Chicago. He said they were doing “interesting things with mathematics.”
I deeply regret listening to that guy, and I only looked him up just now – sadly, he has passed away.
Believing him, I went for an interview at A. G. Becker & Company in downtown Chicago. The interviewer said – basically – he didn’t want to ask me any questions about my work because he wouldn’t know what I was talking about. But I was hired.
I didn’t know what stocks were. I didn’t know what bonds were. I might possibly have heard of them. I might have thought they were the same thing.
When I started in July 1971, I was given a book to read, Investments by William F. Sharpe. I read it carefully. I thought the theory – Markowitz’s efficient market algorithm and Sharpe’s capital asset pricing model – was kind of neat. As I recall, I especially got a kick out of Sharpe’s argument for the capital market line that is also in his classic paper, which I have reread a couple of times more recently.
Since I was the only one with an advanced academic background (except for one salesman who claimed to have a PhD in chemistry) I was the one to communicate with academia. They said they had hired a young university professor as a consultant, so why don’t I go have lunch with him.
When I did, I found it amusing. Myron Scholes admitted to me at lunch that he had “wanted to get his PhD in mathematics, but I couldn’t hack it.” When I asked him what he was doing for A. G. Becker he said “I dunno.”
I hadn’t realized that such people are hired as window dressing (and I later realized that maybe I had been too), not to actually do anything.
A. G. Becker then started sending me to conferences, supposedly on quantitative finance. There were mainly two of them, the Center for Research in Securities Prices at the University of Chicago (CRSP) and the Institute for Quantitative Research in Finance (IQRF).
My first conference was in October 1971 at Dartmouth College in Hanover, New Hampshire. It was the first time I had stayed in a nice motel room.
The only talk that I remember, was because I realized long afterwards that it was a significant event. But it didn’t seem that way at the time. The young presenter – younger than I was, I think – though I don’t remember his name, must have been Keith Schwayder of the Samsonite founding family, who plays a role in Trillions.1 I didn’t know what he was talking about – not yet – but it seemed to interest the other attendees greatly, though they were also slightly bewildered.
This was a presentation about the first live index fund, the $6 million Samsonite pension fund, run by WFIA.
In later conferences, as I was able to pay a little more attention because I understood better what they were talking about, I began to notice that although almost all the speakers wrote mathematics on the blackboard (yes, blackboards), the mathematics was almost universally dreadful – either trivial, unnecessary, or wrong.
I also discovered that people at A. G. Becker knew no mathematics at all. When I met with my boss at the office for the first time, he said, “So you’re a mathematician! You must know something about rates of return!”
My thought was, “Doesn’t everybody here??” (This was supposed to be Becker’s area of expertise.)
No, they didn’t.
After a little while I began to be a gadfly at conferences. I challenged Bill Sharpe after a talk (I might have been a little tipsy from wine at lunch), asking him what practical application this all had.
Beta was all the rage. These people thought they had it all solved. All you had to do was choose a beta and keep it constant.
At another conference I asked Fischer Black, “Why would you want to keep your beta constant?” Looking a little baffled by the question, as if no one had thought of it before, he answered, “Well, you want to keep your risk constant (don’t you?)”
My feeling was that this field is incredibly lacking in richness of thought and lacking even more in richness of mathematics.
The result of my gadfly episodes was that I was called by the organizers of the October 1973 CRSP conference and asked if I would be willing to debate the resolution, “The capital asset pricing model Is of little practical value,” at the October session. I agreed eagerly.
I had heard that the new quantitative gurus of this profession invited a sacrificial lamb to speak at their conferences from time to time – usually a stick-in-the-mud non-quantitative good-old-boy – to ridicule him (yes, of course, him).
At the conference session, my debate opponents were a tag team, John O’Brien, who headed his own company named O’Brien Associates, which had developed its own stock market index of 5,000 stocks, and his employee Dennis Tito.
I had decided the best way to go about this was to use humor. So I dwelled at length on a comical analogy of a measure that I labeled with the Greek letter “omicron” (yes, that omicron) as a measure of the height-to-weight ratio of the average person (meant, of course, to be an analogy for beta). I gave the history of the development of omicron, and how an academic study had empirically ascertained its value. But then another academic study found that this number was wrong. But the first set of academics said that the second study was wrong because the researchers had measured the heights and weights of their subjects three times a week after breakfast, when they should have measured them twice a week before dinner. To mock the conference organizers, James Lorie and Lawrence Fisher, I gave the academicians in my omicron story the names Professor Corey and Professor Wisher.
The audience laughed and cheered. John O’Brien – with whom, it turns out, I’ve had a longstanding relationship since – got flustered. I’m sure I won the debate.2
But one of my exhibits was a graph I had derived from Becker’s data, which showed that there was no clear relationship between beta calculated from regressions, and rates of return.
I was contacted afterwards by someone from the Financial Analysts Research Foundation, who apparently thought it was an important result and wanted me to write an article about this.
I thought he had completely missed my point. My point was that you can’t glean any meaningful results from such messy and random data by running regressions. But here he was, impressed by my unimportant finding from a small amount of messy and random data. I either declined the offer or just didn’t respond, I don’t remember.
I persisted with the field for a few more years so as not to be a quitter, before I finally realized that I was meant to do something else. In 1978 I was deliriously happy to have landed a job at the Solar Energy Research Institute (now the National Renewable Energy Laboratory), nestled at the foot of the mountains of Colorado. This involved a gigantic reduction in salary, but I didn’t mind a bit (later, I admit, it became a problem).
Was it really the theory that led to index funds?
Trillions traces the development of modern portfolio theory – from Markowitz’s efficient portfolio theory, to Sharpe’s CAPM, to Fama’s efficient market argument – as if it was that series of developments which led to the index fund.
At the same time, I was reading another book, A Shot to Save the World, by Greg Zuckerman, about the development of vaccines against COVID-19 (more about that later). This book chronicles the history and development of the experimental and theoretical biology that ultimately led to BioNTech’s and Moderna’s vaccines and other vaccines.
The two books appear to trace two different fields through their stages of development, each stage building on the former stages until finally an important result is achieved.
But are they really the same?
No. The index fund didn’t need Markowitz’s theory, or Sharpe’s. In fact, it only needed the simple arithmetic of investment management, the arithmetic that anyone could have identified, but that is usually traced to Sharpe’s 1991 classic article, “The Arithmetic of Active Management.”
The simple idea of The Arithmetic of Active Management is that it’s not possible for everybody to beat the average of everybody. The mistaken idea that it is possible is sometimes labeled the “Lake Wobegon Effect,” for “Prairie Home Companion” host Garrison Keillor’s fictional town of Lake Wobegon, where “all the children are above average.”
But maybe it’s possible for some of the children (money managers) to beat the average all of the time (or at least most of the time).
That’s the only place where the other thing you need comes in (but as I’ll show in a moment, you don’t need it) – efficient pricing theory.
If prices are efficient (for whatever reason), then nobody can second-guess the correct price of a security. If prices only change due to unpredictable future events, which come along randomly, then beating the average is an accident and can’t be expected to repeat.
The latter argument may seem a little iffy, and certainly people debate it, all the time. Efficient market theory, in fact, holds the seeds of its own debatability (if I may coin a non-word) because its justification is that when (inevitably) the market becomes just a little inefficient, profit-seekers swoop in to make it efficient.
But you don’t need efficient market theory either. Suppose there are investment managers or strategies that always beat the average. Investors will flock to them, abandoning all others and moving the average up to the average of those that “always work.” That will keep happening.
It also helps, of course, that there is an overwhelming mountain of evidence that highly-paid professional investment managers can’t persistently beat the averages.
Markowitz’s and Sharpe’s contributions, as interesting as they are as thought experiments, are not necessary to point to a low-cost index fund as the most cost-effective way to invest in the market.
But then why are they all so “brilliant”
I noticed in Wigglesworth’s book a phenomenon I’ve noticed in other books about investment managers and finance. Somehow the protagonists are all “brilliant.”
I decided to take a count.
In Wigglesworth’s book, 17 people are identified as “brilliant.”
Then I took a count in Zuckerman’s book about vaccine development. Exactly one person merits the label “brilliant.”
Is this because people are much more brilliant in the investment management field than in vaccine development? Or in the index fund development field specifically? Or is it a feature of the different styles of the two authors?
No, I don’t think it’s either. This often happens in books about the field of finance, especially about money management. I saw it before in a book about the hedge fund industry called The Quants, by Scott Patterson. In my review of the book, I wrote that it was “drenched in the hyperbole that seems, for some reason, to be obligatory when talking about quants in the investment field: ‘brainy math whizzes’; ‘theoretical breakthroughs in the application of mathematics to financial markets’; ‘brain-twisting math’; ‘superpowered computers’; ‘advances that had earned their discoverers several shelves of Nobel Prizes’.”
Later I read – and reviewed – another book by the same author, Scott Patterson, and found that he is, in fact, an excellent journalist. In that book, Dark Pools: The rise of A.I. trading machines and the looming threat to Wall Street, Patterson had to track down and explain a great deal of intricate findings. But when there isn’t very much there, journalists resort to hype.
Is it just index funds?
Is the answer index funds? As soon as something becomes popular, people build shibboleths or corrupted modifications around it. In the case of index funds, two such corruptions are to be found.
One is the explosion not only of index funds but of indices. Anything can be an index fund, so long as it conforms to an index. And so now, Wigglesworth says, according to The Index Industry Association (yes, there is an Index Industry Association), there are nearly three million “live” indices being maintained by its members.
A second corruption is the obsession with “tracking error.” Neither the theory – even including all of the MPT foundation, if it is that – nor the commonsense derivation of the superiority of a low-cost broadly diversified portfolio, requires that it absolutely minimize tracking error. Wigglesworth makes the interesting observation that Dimensional Fund Advisors, which was originally started to add a small-cap fund to pension funds’ S&P 500 funds, was lucky in its early days because there wasn’t an index that it had to adhere to. So it had the leeway to wait for a good trade before including (or ejecting) a stock in its portfolio.
The common sense development of the principle of index funds doesn’t say that you absolutely have to adhere strictly to any specific index. It does say that a total market portfolio is, just marginally, the best, but since it’s not perfectly clear exactly what a total market portfolio is, it shouldn’t be obsessed about.
The basic result is that if your objective is to get the best return on your investment, it’s not worth spending a lot of money for someone to pick securities for you, as long as you can assemble a reasonably well-diversified set of securities yourself (or someone can do it for you cheaply, like an index fund manager).
That’s about it.
Do you need “brilliant” people to figure this out and develop it?
Brilliant and dedicated communicators like Jack Bogle, yes, perhaps, but the rest requires no advanced intellect.
Index fund tribulations
In the latter part of the book, Wigglesworth focuses on arguments that have arisen of late that if too much of the market invests in index funds, it could be dangerous.
Most of these concerns are without merit, and some of them are concerns not about very broad (i.e. total market) indexing but about indexing to subsets of the market (including the S&P 500). But one of the concerns, a concern that was raised most prominently by Bogle himself, could be a real issue.
As to the concerns about indexing to subsets of the market, Wigglesworth presents some convincing examples. For example, Tesla’s price surged upward by an astonishing percentage when it became eligible for admission to the S&P 500 index. The price surge had nothing to do with Tesla’s fundamental value as measured by its potential for profit. The surge was due to nothing but its admission to the S&P 500 index, which meant that a substantial percentage of the hundreds of billions of dollars invested in S&P 500 index funds would suddenly have to buy it.
In a way, one might say that the automated but often irrational rules of index inclusion are substituting for what had previously been assumed by technical analysts to be the predictable irrationalities of the aggregate of investors.
Except that the inclusion or exclusion of securities in an index is predictable. And so, as Wigglesworth notes, those sudden market moves when a security is accepted by an index have begun to dissipate.
But Bogle’s warning is much more important, and will be increasingly debated in the near future, especially with the rise of investing trends like “sustainable investing” and “ESG investing.”
Bogle’s concern is that because only three index fund management firms (advised by their proxy-voting consultants) – Vanguard, BlackRock, and State Street – own large percentages of virtually all companies and therefore have the power to vote their investors’ proxies, they hold oligopolistic power over corporate shareholder voting. So far, these large index fund management firms have not done anything startling with that power – which by some people’s lights, could be a problem in itself, since they are not shaking things up either.
But that power exists and needs to be thought through.
Index fund investing is big and getting bigger and will be with us for some time. And it is without question, on the whole – particularly very low-cost investing in total market indices – a positive development for the average investor. For this, we can thank the personalities populating Wigglesworth’s book, most especially Jack Bogle.
Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, managing partner and special advisor at M1K LLC, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.
1Since writing this article I have learned that the presenter was not Keith Schwayder but Wayne Wagner of Wells Fargo.
2There’s a mistake in Wigglesworth’s history. It says, “IN 1975, BOOTH [David Booth, co-founder of Dimensional Fund Advisors] LEFT WELLS FARGO to work in New York for AG Becker.” But before he left to work for A. G. Becker, Booth was working at O’Brien Associates. O’Brien, as I heard it, had suffered a palace coup which ejected him from his own company, subsequently renamed Wilshire Associates, and the O’Brien 5000 renamed the Wilshire 5000. In moving to A. G. Becker, John brought his O’Brien Associates employees Gil Beebower, Richard Ennis, and David Booth with him. I was assigned to join them though I left Becker soon after that.