The dramatic growth in exchange-traded funds (ETFs) is the most recent evidence of public enthusiasm for index investing. When any phenomenon achieves the level of success that indexing has enjoyed - whether the phenomenon is an investment technique, a medical miracle or a media celebrity - it is usually a good idea to check that the success is fully deserved. In the case of indexing, there is certainly a great deal of merit in the idea, but also some weaknesses in the execution. Curing these weaknesses requires sound diagnosis and strong medicine. This column and a column that will appear in the next issue of this journal will try to address some questions about indexing that are the index fund equivalent of: "Why did Humpty Dumpty's shell break so easily?" or "Is the naked Emperor an exhibitionist or a fool?" Such questions may seem silly in a serious publication, but they are a call to think about index funds outside traditional frames of reference. The best way to understand the problems and the cure is to start with a clear statement of the fundamental principles of index investing.
Indexing Has A Strong And Solid Foundation
Peter Bernstein's history of the development and application of the great ideas of finance, Capital Ideas (1992), makes it clear that indexing was part of a broader plan. The unifying objective of the indexing pioneers was to replace the traditional trust department dog-walking (personal service) and stock-picking (active portfolio management) with portfolios that had more diversification and a more "scientific" construction. Increasing portfolio diversification and eliminating the costs of securities selection and active trading were as important as lowering operating costs in the minds of most early advocates and practitioners of indexing.
In the first edition of his perennial best seller, A Random Walk Down Wall Street (1973), Burton Malkiel called for "A New Investment Instrument." He said, "What we need is a no-load, minimum-management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners."
In 1974, Paul Samuelson set down some arguments he had been making among the investment community in the Journal of Portfolio Management. He noted that, "The only honest conclusion is to agree that a loose version of the 'efficient market' or 'random walk' hypothesis accord s with the facts of life."
Samuelson questioned why no money management organization offered an unmanaged diversified fund to the public. He believed that this could be done at relatively modest cost and that the fund would probably be a better repository for his savings than most actively managed funds.
Less than a year later, Charles D. Ellis, in one of the most widely cited papers in the literature of both finance and tennis, marshaled some simple facts illustrating that the institutionalization of the equity markets in the 1960s and early-1970s had made it probable that the average institutional investment manager would underperform the market as measured by a representative index. Ellis observed that the costs of trading actively managed institutional portfolios and paying administrative expenses and management fees combined with the increased institutional share of the market create an expense hurdle and leave too little stock in the hands of nonprofessional investors to let amateurs fill the ranks of underperformers. Institutional investing, like amateur tennis, has become a loser's game, where the winner is the player who makes the fewest mistakes or has the lowest costs. William Sharpe made the same case a few years later with equal elegance, but less athleticism.
John Bogle of Vanguard was as motivated by the desire to reduce investor costs in 1975 as he is today. Like other indexing pioneers, Bogle endorsed indexing as a way to lower costs (largely sales, trading and management costs) and improve performance. Bogle was pleased when his first index fund was large enough to own all of the 500 stocks in its benchmark index. His pleasure reflected the fund's growth and the diversification it had achieved with appropriate trading cost constraints that delayed the appearance of all the index members in the fund portfolio. He has never been a zealot in pursuit of precise index tracking.
While I do not claim my search was exhaustive, I have found nothing in the works of the indexing pioneers that suggests an index fund manager should incur added costs or take extraordinary pains to replicate the performance of an index exactly. The drive for precise index replication to minimize a fund's index tracking error - especially when close tracking means the fund will underperform is the fetish of a later generation of index fund managers. As the indexing pioneers saw it, index managers are not expected to generate a lot of alpha; but they are not expected to lose it either.
For all of the indexing pioneers, the index itself was a means to higher ends. None of these wise men anticipated the scale of indexing's success or, ironically, the high costs which the index management and publication process imposes on many of today's index fund investors. It is time to consider how the cost of indexing's success harms today' s index fund investors. As an industry, we need to reassemble Humpty Dumpty and give him a stronger shell.