/Passive attack: the story of a Wall Street revolution

Passive attack: the story of a Wall Street revolution

Every year, hordes of aspiring investors make the pilgrimage to Omaha, hoping to learn at the feet of Warren Buffett at Berkshire Hathaway’s annual meeting. But for more than two decades the Sage of Omaha has offered the same staid advice: just buy an index fund.

In fact, earlier this year Buffett won a wager that a cheap index fund, which does nothing but track the US stock market would, over 10 years, thrash an elite crew of hedge funds picked by Protégé Partners, a Wall Street investment firm. Buffett hammered home his message in his latest annual letter to shareholders.

“During the 10-year bet, the 200-plus hedge fund managers that were involved almost certainly made tens of thousands of buy-and-sell decisions. Most of those managers undoubtedly thought hard about their decisions, each of which they believed would prove advantageous. In the process of investing, they studied 10-Ks [a company’s annual report], interviewed managements, read trade journals and conferred with Wall Street analysts,” he wrote.

And yet, the nearly free, “dumb” index fund prevailed, returning 126 per cent over the decade, while the hedge funds made a more modest 36 per cent.

Index funds are vehicles that simply attempt to mimic a market benchmark — whether the FTSE 100, the S&P 500 or developing country bonds — as cheaply as possible. Some are unmanaged mutual funds, others are exchange-traded funds (ETFs) that can be bought and sold throughout the day, just like any stock.

While their genesis can be traced to the 1970s, the shift towards passive investing has been seismic since the financial crisis. The global index-tracking-fund industry now manages nearly $10tn, according to the Investment Company Institute — making it almost twice as big as the hedge fund and private equity industries combined.

Index funds have revolutionised investing, saving millions of people untold billions of dollars in fees that would otherwise have gone to fund managers with a dismal long-term record of actually beating the market. It is no exaggeration to say that the rise of passive investing is probably one of the most consequential financial inventions of the past half-century. It is rewiring markets and reshaping the finance industry.

Yet some detractors say that index investing is an insidious disease. According to a critique by analysts at Bernstein, passive investing is “worse than Marxism”, because at least communists tried to allocate resources efficiently, while index funds just blindly invest according to an arbitrary benchmark’s formula. Paul Singer, a famed hedge fund manager, even argues index funds are “devouring capitalism”.

Proponents laugh this off as scaremongering. “Whenever something goes bad, we now blame ETFs. But it is one of the greatest financial innovations of all time,” argues Deborah Fuhr of ETFGI, a prominent industry analyst, who believes index funds have become the “punching bag” that hedge funds used to be.

By the 1960s better data and more powerful computers led to the dawning realisation that most fund managers actually did a poor job — and people began to investigate why © Yale Joel/Life Magazine/The LIFE Picture Collection/Getty Images)

The trend towards passive investing has profound implications for the finance industry, where an army of analysts and traders exist solely to help portfolio managers invest our money.

As the novelist Gary Shteyngart observed to investment magazine Barron’s in September: “Everyone in New York who’s not a portfolio manager is just this little helper animal, and their existence is tied into the health of the greater animal. If the main animal perishes, the whole ecosystem goes.”

Indeed, even some of the passive investment industry’s pioneers concede that its rampant growth raises important questions that need to be addressed. But how did this revolution spread, how is it changing markets, and how far can it go? To understand where we are going, it helps to understand where we came from. And for that, we need to wind the clock back half a century.

The early rebellion

John McQuown grew up on his family’s farm in rural Illinois, far from the bustle of Wall Street, and was the first in his family to get a higher education, graduating with a degree in mechanical engineering from Northwestern. After two years on a US Navy destroyer, McQuown took an MBA and, in 1961, started at Smith Barney, a storied Wall Street brokerage. Then, serendipity struck.

At night and over weekends, McQuown and a friend moonlighted at a new company, renting a hulking 7094 IBM mainframe computer in the basement of the Time-Life building for $500 a shift to generate reams of esoteric stock market data. IBM, keen to show off the versatility of its machines, invited the young man with a big mop of hair to present his work at a conference in San Jose in 1964.

John McQuown (pictured in 2015), whose pioneering work in the 1960s laid the foundations for passive investing

One of the attendees was Ransom Cook, the chairman of Wells Fargo, at the time a venerable but sleepy regional bank of little consequence. Intrigued, he asked McQuown to lead a new research team dedicated to more analytical, rigorous investing. “His suspicion was that what they were doing wasn’t really leading to an improvement of investment management,” McQuown tells me.

This was a heretical thought for anyone in the investment industry, but one that had been gaining ground. In 1940, a former stockbroker called Fred Schwed had published a book titled Where are the Customers’ Yachts?, an acerbic take on Wall Street that has since become a classic.

By the 1950s there was fresh interest in measuring and analysing market performance, and in 1957 Standard & Poor’s launched the first computer-calculated stock index of America’s biggest companies, “a symbol of the beginning of the electronic era in finance”, according to Robert Shiller, the Nobel economics laureate.

By the 1960s better data and more powerful computers led to the dawning realisation that most fund managers actually did a poor job — and people began to investigate why. “That’s when, in a sense, life begins,” says David Booth, the chairman of Dimensional Fund Advisors. “All of a sudden, computers are around, and a dozen landmark papers were coming out every year.”

The University of Chicago and MIT were at the centre of this nascent financial-academic revolution. In 1965 Eugene Fama, the famed Chicago economist, first articulated his “efficient markets” hypothesis, which stipulated that securities fully reflect all known information, and the market cannot be beaten.

But even for those who believe that markets are inefficient, there is a simple, inescapable mathematical truth: the market is made up of investors, so the average investor cannot do better than the market. For every one that beats it, someone else must fall short.

And when the cost of trading and the fees charged by a fund manager are factored in, the average investor will, in fact, underperform the wider market, points out Burton Malkiel, the Princeton economics professor and author of A Random Walk Down Wall Street. Some skilled managers might beat the market in any given year — or maybe even over a decade — but identifying consistent stars has proven to be tricky both in theory and practice. “The intellectual case for indexing is airtight,” Malkiel says.

The implications of this dawning conclusion were what McQuown and his new Wells Fargo Management Sciences division sought to explore. He assembled a 35-person team and recruited a cast of eminent economists as advisers and consultants, several of whom would go on to win Nobel Prizes. This was the Manhattan Project of investing and, ultimately, helped birth a nuclear bomb that would rip through the global asset management industry.

Disrupting a lucrative status quo is tough work, however, and insiders tell tales of vicious office politics and epic shouting matches that shook the walls of Wells Fargo. “It felt like shovelling shit against the tide,” McQuown recalls. “We weren’t very popular, even at Wells Fargo initially.” But he had a potent ally, a former jazz saxophonist called William Fouse, who would also write his name into the history of passive investing.

After graduating from the University of Kentucky, Fouse had drifted into a job at a Pittsburgh lender called Mellon Bank and quickly became entranced by the rash of academic work emanating from Chicago. He suggested that Mellon start an index fund, but his boss was underwhelmed. “He accused me of trying to turn his job into a science,” Fouse recalls. “So I fled.” McQuown snapped him up.

Wells Fargo’s revolutionaries still needed the faith of outside investors to put their ideas into practice. Their first was a young University of Chicago graduate called Keith Shwayder. In 1970, he joined his family business Samsonite, and was shocked to discover that its pension fund was invested in a motley bunch of mutual funds — anathema to someone steeped in the cutting-edge research of his alma mater.

He asked his former tutors if anyone was currently managing money in the “theoretically proper” way, and was promptly sent to McQuown. By July 1971 the first index fund was born, with $6m from Samsonite’s pension fund.

July 1971: Keith Shwayder (seated) reinvests $6m from Samsonite’s pension fund to create the world’s first index fund © Bill Johnson/The Denver Post/Getty Images)

Initially, it was not a success. The strategy was to hold an equal dollar amount of each of the New York Stock Exchange’s 1,500 stocks. But the implementation was a logistical nightmare. Constantly rebalancing to make sure the weightings were correct was difficult and expensive. So by 1973 Wells Fargo set up a new fund that simply tracked the S&P 500 — weighted by the market value of each constituent. Soon afterwards, Samsonite folded its fund into Wells Fargo’s simpler S&P 500 index fund.

Roughly at the same time, executives at Batterymarch, a Boston-based investment group, and the American National Bank of Chicago launched index funds. Dean LeBaron, co-founder of Batterymarch, says all these pioneers stood on the shoulders of the same academic giants. “Who knows who really got there first? There are at least 20 fathers of indexing.”

Nonetheless, the impact of McQuown’s Management Sciences division was undeniable. In 1970, Wells Fargo’s staid trust department managed about $5bn. That rose to almost $15bn by 1980 — by which time it had virtually abandoned all active money management — and more than $80bn by 1990, according to Capital Ideas by Peter Bernstein.

Yet it was another iron-willed financier who took the index investing revolution to the masses.

The revolution spreads

On January 23 1974, John Clifton Bogle strode into the boardroom of Wellington Management Company’s Valley Forge headquarters. He was expecting to be sacked but the coup that ousted him still came as a blow to the one-time wonder boy of the investment industry.

“Jack” Bogle had until then known little but success. His aptitude for mathematics led to an economics degree from Princeton, where his thesis on investing caught the eye of Walter Morgan, the founder of Wellington, a pedigreed Philadelphia investment group. By the time Bogle was 35, he was Morgan’s heir apparent, and soon afterwards picked up the reins.

But then Bogle made a fateful mistake, merging Wellington with an aggressive young mutual fund company in Boston. When the stock market tumbled in 1973, Wellington found itself on the ropes, and the new partners abruptly defenestrated Bogle. “It was devastating,” he ruefully told me. “But I was determined to win at the craps table what I had lost at the roulette table.”

Wellington might have been the manager of its funds, but it still had an independent board — and Bogle remained the chairman. The very next day he took the 6am train to New York and proposed they declare their independence.

The counter-coup failed but the board agreed to create a new subsidiary company that would have fund administration as its sole responsibility and Bogle as its chief executive. And thus The Vanguard Group — named after Nelson’s flagship at the Battle of the Nile — was born.

Bogle had no intention of settling for the humdrum tasks of fund administration. Instead, a cri de coeur from one of the world’s most illustrious economists stirred his imagination. That autumn Paul Samuelson, an MIT professor who had recently become the first American to win the Nobel Prize for economics, published an article pleading for an index-tracking mutual fund to track the S&P 500 — for ordinary investors, not just pension funds and insurers. This was music to Bogle’s ears. “It was inspiring and readable,” he recalls. “It was a seminal point for the company we were starting.”

Still, the project was initially an abject failure. Vanguard hoped to raise $150m but the brokerages that arranged its sale struggled to persuade investors to put their money in. In August 1976, the First Index Investment Trust went live with a measly $11m, and was quickly dubbed Bogle’s Folly.

Fidelity’s chairman Ned Johnson said: “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns on their funds.” Some rivals even called it “un-American” and distributed posters mocking it. “It was a joke,” Bogle recalls. “The underwriting was probably the biggest failure in Wall Street history.”

“I believed the numbers would ultimately tell. The superiority of the index is guaranteed. The math will never let you down” – Jack Bogle, Vanguard founder

But the setback only fuelled his determination. Even those close to him would occasionally poke fun at his messianism. Each year he hosted a Christmas dinner for all his past and present assistants, and one year they presented him with a clerical collar to wear — to the amusement of everyone except Bogle. “We thought he had gotten a little self-righteous, and got him a clerical collar for when he got evangelical. He didn’t think it was as funny as we did,” recalls Jim Riepe, Bogle’s first assistant. “He could be a tough person to work with.”

Bogle admits that he was a zealot. “It was a crusade. If you really believe in something, you have to become a preacher,” he says. “I believed the numbers would ultimately tell. The superiority of the index is guaranteed. The math will never let you down.” By the end of 1976, the Vanguard fund still languished with $14m. But in 1982, it crossed $100m. By 1988 the fund boasted $1bn. By 1996 it crossed $10bn. Today the now-renamed Vanguard 500 Index Fund manages more than $400bn.

One of the reasons for Vanguard’s success is its unique structure. Bogle constructed it to be owned by its own funds, which are in turn owned by its investors. In other words, it is a true, mutually owned entity, ensuring costs and fees are kept at a minimum. The implications are mind-boggling.

In a 2016 tribute to “a real f**king people’s hero”, the writer Hamilton Nolan said: “John Bogle founded a multitrillion-dollar investment firm and did not use it to make himself into a multibillionaire but instead used it to produce a good product at a fair price that saves money for everyone who uses it.”

Bogle says he appreciated Nolan’s sentiment — if not the strong language — and bristles with pride over Vanguard, even if it didn’t bring him the financial rewards that other investment behemoths have brought their founders. “What do I need a private jet for? I need my wife to drive me around. It doesn’t do my psyche any good to know that I have more than someone else,” he says. “I’m very comfortable with what I’ve done for the world.”

The index revolution 2.0

One bright morning in early 1992, Bogle received a visit from an avuncular former submariner called Nate Most who had a wild idea for how to resurrect the fortunes of his employer, the American Stock Exchange. Little did either know that the pitch, which Bogle summarily dismissed, would turn out to be a game-changer for modern finance — the exchange-traded fund.

Most, who died in 2004 at the age of 90, had studied physics and worked on a US Navy submarine during the second world war. He then travelled through Asia as a salesman and eventually stumbled into the cooking oil business. While working at the Pacific Commodities Exchange, he observed how commodity traders would buy and sell warehouse receipts rather than physical barrels of oil or ingots of gold.

“You store a commodity and you get a warehouse receipt and you can finance on that warehouse receipt. You can sell it, do a lot of things with it. Because you don’t want to be moving the merchandise back and forth all the time, so you keep it in place and you simply transfer the warehouse receipt,” he later recalled to ETF.com.

Decades later, Most ended up as head of product development at the American Stock Exchange, a venerable institution that had fallen on hard times. Ironically, the Black Monday crash on October 19 1987 — the worst day of wealth destruction Wall Street has ever witnessed — provided him with the break he needed.

October 19 1987: Traders in New York crowd the stock exchange floor on Black Monday, when the US stock market fell by more than 20% © UPI/Jon Simon

The Securities and Exchange Commission’s subsequent autopsy blamed an algorithmic trading strategy called “portfolio insurance” for the crash. Intriguingly, the post-mortem suggested that if traders could have turned to a single product for trading entire baskets of stocks, it might have ameliorated the turmoil. Most and his young sidekick Steven Bloom quickly set about engineering such a product.

One idea was to see whether existing index funds could be listed and traded just like a stock. But Most’s visit to Vanguard did not go well. “Nate Most was a fine gentleman but it was the antithesis to what I like,” Bogle says. “I said, ‘You want people to be able to trade the S&P but I just want them to buy and never sell it’.”

Most remained undeterred. By then he was already far along his path towards creating the first ever ETF with State Street. Just as his former colleagues would trade paper receipts for physical commodities, Most envisaged a structure where brokerages — or “authorised participants” in industry jargon — would continually create, redeem and facilitate trading in electronic shares of a passive basket of shares.

“Nathan was a brilliant innovator. Always thinking outside the box,” says Jim Ross, then a junior member of the State Street team, and now head of its global ETF business.

Unfortunately, jumping over all the regulatory hurdles took time, allowing Canada to steal ahead. In 1990, the Toronto Stock Exchange unveiled the world’s first successful exchange-traded fund. But on January 29 1993, the Standard & Poor’s Depositary Receipts (SPDR, usually just referred to as “Spider”) finally began trading.

Not only is SPDR now a $265bn behemoth, it is also the most traded equity security on the planet: everyone from hedge funds in Connecticut to day-traders in Ukraine uses it to punt on the US stock market. But “Spider” is only the crown jewel in what is now a staggeringly vibrant, complex and rapidly expanding $5tn ETF universe that allows anyone to bet on anything from risky loans or African stocks to companies approved by the US Conference of Catholic Bishops, or the nascent music-streaming industry.

Even more than index funds, ETFs are fundamentally reshaping the investment industry. Their tradeability means they can be used as Lego-like building blocks for strategic portfolios or tactical punts, by anyone from sophisticated hedge funds to ordinary retail investors. “Now everybody can invest globally,” says Mark Wiedman, head of BlackRock’s index fund business. “That was one of the huge impacts of the rise of ETFs.”

For a time, many fund managers hoped the growth of passive investing would open up lucrative anomalies for them to exploit. Instead, the performance of active managers has actually deteriorated. Michael Mauboussin, head of research at BlueMountain Capital, compares this to a poker game where poorer players — the dumb money — get wiped out quickly, making the game harder for the remaining card sharps.

Jeremy Grantham, the founder of GMO, a Boston money manager, reckons this logic will hold at least until index funds account for 90 per cent of the market — a distant prospect. “Asset management is getting tougher and tougher. The argument that it will become easier is nonsense,” he warns.

However, great success can breed resentment and fear. Given the index industry’s size — up fivefold from $2tn on the eve of the financial crisis to nearly $10tn today — and growth trajectory, concerns over its impact are only going to multiply in the coming years. Even some of its champions now admit to growing unease. “Even back then, we would discuss whether it could go too far. It seemed a silly discussion at the time, but not so much now,” says LeBaron. “Everything goes too far, doesn’t it?”

The future

On February 14 2018 Nikolas Cruz used a semi-automatic rifle to murder 17 people in six minutes at his former school in Parkland, Florida. In the aftermath of the tragedy, index funds suddenly became part of the debate, after activists called for a boycott of BlackRock and Vanguard over their big shareholdings in gunmakers.

This was awkward for the two index fund behemoths. Traditional, active fund managers can always sell companies that they or their investors dislike but index funds cannot sell as long as the companies remain in indices they track.

In an attempt to mollify the backlash, Vanguard said it met gunmaker executives and “sought to understand how the companies plan to help prevent similar tragedies from happening again”. BlackRock promised it would offer its investors vehicles that exclude gunmakers and talk to those it was already invested in.

However, the imbroglio highlighted what is emerging as the pivotal battlefield for the future of the index fund industry: how, when and why should they exercise their considerable and expanding power over companies around the world? “It’s a serious issue, and everyone that says it isn’t, isn’t telling the truth,” admits Bogle.

The concerns about what the growth of passive investing means for corporate governance are multipronged and conflicting — but sometimes have a kernel of truth to them. Some say index funds are lazy owners, leading to unaccountable management and ultimately sapping the economy of its dynamism. Others worry they are becoming too activist, stepping into controversial public policy issues better left to regulators and politicians.

© Cajsa Holgersson

As the Parkland tragedy underscored, navigating the pressure to be socially aware investors, the reality of what index funds can actually do and the backlash they could engender if they overplay their hands is a tricky task that will only become more difficult in the coming years.

There is another big question as well: whether index funds help fuel bubbles or increase the fragility of the global financial system. Of course, markets have always been prone to bubbles and busts. But because most money goes into index funds that weight by the size of a company, it means they are a pro-cyclical force that can ensure the big get bigger, and companies outside indices languish in the shadows. For example, a decade ago about 15 cents of every dollar that went into SPDR or the Vanguard 500 went into technology stocks; today it is about 25 cents.

The concern is that if money starts seeping out of index funds in a future bear market, it will exacerbate the slump and reveal fragilities in the index fund ecosystem. “The risks related to the rapid growth of index funds represent one of the biggest challenges facing markets today,” argues Paul Singer of Elliott Management.

“The sheer force of flows into these funds has been an important driver of the relative outperformance of indexed assets. When these flows reverse, or even pause, the effects could be just as impactful on relative prices, but in reverse, and possibly more abrupt and intense.”

Recently, a fringe theory — that the rising concentration of shareholders caused by the explosion of index funds appears to be crimping competition — has also started to gain more prominence. Earlier this month, the Federal Trade Commission held an open hearing on the subject.

The index industry says this is absurd, and counters that passive investing remains a minor player in the grander scope of global financial markets. And without a doubt, index funds are one of the largest, most disruptive innovations the finance industry has seen in the past century. Evidence that they are somehow wrecking markets is scant, and the benefits have directly and indirectly accrued to every saver on the planet in the form of cheaper fees.

But the implications of the industry’s swelling heft — and especially the “Big Three” of BlackRock, State Street and Vanguard — should not be dismissed lightly. Every great invention comes with side effects that should be recognised and addressed. Within the foreseeable future, they could hold a commanding vote in most major US public companies — a development that worries even Bogle.

“Is that good for capitalism?” he questions. “It’s hard to know how big we can get, and the consequences. But it does raise issues that we need to address. We cannot ignore them. But to solve this we should not destroy the greatest invention in the history of finance.”

Robin Wigglesworth is the FT’s US markets editor

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