Indexing standing the test of time
When it comes to investing, I have long adhered to a simple acronym: KISS, which stands for “Keep It Simple, Stupid.” As a result, when I receive questions about how to select the “right” portfolio allocation, I usually end up recommending a mix of index funds or index-based exchange traded funds (ETFs), which track an established stock, bond, real estate or commodity index. Indexing allows investors to diversify their risk for a fraction of the cost that managed funds charge.
Though I have been a fan of indexing for decades, I did not know the origin story until I interviewed Robin Wigglesworth, the Global Finance Correspondent for the Financial Times and author of the new book, “Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever.”
According to Wigglesworth, the elegant investment solution that index funds provided can be traced back to a time before Vanguard founder Jack Bogle's 1976 Vanguard First Index Investment Trust, or Charles Ellis' 1975 article, “The Loser's Game,” the famous missive that quantified active managers' disappointing results versus passive investments. Wigglesworth explores the index fund's roots all the way to a Depression-era analyst named Alfred Cowles III, a student of speculation and financial markets.
Building on the research of a turn-of-the-twentieth century French mathematician named Louis Bachelier, Cowles' released a fundamental building block for the advent of indexing. His 1933 article was titled “Can Stock Market Forecasters Forecast?,” and the answer was “a terse, brutal threeword abstract: ‘It is Doubtful.'” Wigglesworth notes that Cowles' calculations “indicated that only a minority of prognosticators managed to do better than the stock market as a whole, and blind luck might explain those.” Nearly 90 years later, the results are eerily consistent.
Wigglesworth told me that “the math around indexing is irrefutable,” a notion that S&P, the company that licenses its indexes to various fund families, echoes in its annual analysis. While in any given year, a managed fund might beat its relevant index, over longer time horizons, those that survive rarely beat their bench marks.
When I have trotted out that kind of data to managed fund adherents, they have warned that the proliferation of index funds and index ETFs would mean that all investors would be subject to a dangerous and risky herd mentality. The theory was that when investors are riding high amid the good times, few would worry about being in a crowded trade. But the fact that so many would have piled into the same index could turn disastrous during a market collapse, as the once-confident herd of bulls would charge for the exit at the same time.
“The worry among some skeptics,” says Wigglesworth, is that struck with a barrage of withdrawal requests, especially in the more thinly traded bond market, an ETF sponsor “might be unable to sell its holdings to meet them, and collapse. That could in turn spark fears over fixed income ETFs at large, leading to a frenzied rush for the
exit that triggers a broader bond market collapse.”
This fear was put to the test amid the early days of the pandemic. March 2020 was perhaps the closest thing we have had to a stress test for passive investing. Instead of withering amid extreme volatility, Wigglesworth said that ETFs acted as a “shock absorber” to the system, not a trigger for collapse. “The turmoil in the broader bond market would likely have been worse had ETFs not existed to absorb the selling spree.”
The investment industry has long reacted to indexing with “a mix of indifference, snickering, snark, and outright hostility,” says Wigglesworth, which makes me a bigger fan of the strategy than ever.