The rise and rise of passive investing

With the passive investment revolution upon us, Robin Wigglesworth's book offers a useful guide

Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever

Author: Robin Wigglesworth

Publisher: Penguin Business

Price: Rs 665

If you are looking for a book that goes deep into the question of what led to the invention and growth of passive funds in the United States, turn to this well-researched tome by Robin Wigglesworth, global finance correspondent at the Financial Times. The author has skillfully woven together the dry theoretical concepts that underpin the creation of index funds with colourful sketches of the key personalities that shaped this revolution.

He begins by recounting the bet between Warren Buffett and Ted Seides, a money manager at a hedge fund called Protégé Partners.

Though Mr Buffett is among the greatest active fund managers ever, he has long held the belief that net of fees, only a small percentage of his peers add value by beating their benchmarks. His scepticism was evident even in a 1975 letter to Katharine Graham, owner of The Washington Post. Graham had sought Mr Buffett’s counsel on how the Post should invest its pension corpus. Mr Buffett replied that if the Post invested with larger money managers, it could expect to trail the benchmarks slightly over the long term. If it wanted outperformance, it should invest with smaller money managers operating in niche markets. The best solution, according to him, would be to invest in a broad basket of stocks that mimicked the markets.

During Berkshire Hathaway’s 2006 annual meeting, Mr Buffett offered his now famous $500,000 wager. The bet ran from 2008 to 2018. Mr Seides pitted five fund-of-funds (hedge funds that in turn invest in other hedge funds) while Mr Buffett went with Vanguard’s S&P 500 index fund. The bet proved utterly one-sided: The Vanguard S&P 500 index fund returned 125.8 per cent over the decade while the five hedge funds on an average fetched only 36.3 per cent.

The problem highlighted by the anecdote above is one that has bedevilled the fund management industry in the US since its early days. A large percentage of active fund managers there have always underperformed their benchmarks.

As early as in 1933, Alfred Cowles III studied the track record of investment recommendation services. He concluded that these forecasters did a poor job of recommending winner stocks.

In 1960, Merrill Lynch gave the University of Chicago a grant of $250,000 for a four-year study on stock market returns over the long term. James Lorie, the associate Dean of Chicago’s Business School, set up the Centre for Research in Security Prices (CRSP) to collect this data. The results, published in 1964, showed that someone who had invested in all the stocks of the New York Stock Exchange in 1926, and reinvested all the dividends, would have made 9 per cent annually by 1960. This study helped stock brokers break the stranglehold that bonds had on the minds of hyper-cautious American investors scarred by the Great Depression.

Another equally momentous finding of the CRSP was that the long-term returns of the US stock markets were slightly higher than the average returns of investment trusts and mutual funds.

The University of Chicago was the hub from which emerged most of the studies that provided the theoretical basis for the launch of passive funds. Harry Markowitz proposed the idea that diversification across stocks reduces risk. Eugene Fama showed that stock markets do a “random walk”. They behave in a manner that makes it extremely difficult to predict their future behaviour based on past data.

In a 1965 paper, Dr Fama proposed the “efficient market hypothesis” which says that competition among market participants ensures that all known, relevant information gets reflected into stock prices instantly. Critics of this theory argue: How can markets, so prone to booms and busts, be said to be efficiently priced? The consensus that now prevails is that while markets do get mispriced in the short term, over the longer term they evolve and turn more efficient. The unavailability of mis-priced stocks makes it harder for fund managers to beat their benchmarks.

Wall Street initially scoffed at the idea of building a portfolio that replicated the broad stock market indexes. Who wants just average performance, was the refrain. However, a few renegades, who were familiar with the studies within academia, decided to launch index funds. In July 1971, the first ever passively managed fund was launched by Wells Fargo Investment Advisors to manage the pension money of luggage maker Samsonite.

These funds were slow to gain acceptance. Institutional investors such as pension funds took to them first. It took decades of proselytising by the likes of John Bogle, the founder of Vanguard, before financial advisors and retail investors adopted them in a big way. Thereafter, growth exploded.   

The passive investment revolution is upon us in India as well. If you are keen to understand why the asset under management of these funds which yield “only average returns” today runs into trillions globally, read this book.