The Devil’s Invention

June 27, 2011

Nearly a decade after introducing the first equity index fund, Vanguard applied the indexing theory to the bond market, using the Lehman Aggregate Bond Index as a benchmark. (This index was renamed the Barclays Capital Aggregate Bond Index in 2008, after Lehman Brothers went bankrupt.) The Total Bond Market Index Fund, reflecting the market value of all taxable U.S. bonds, was founded in late 1986 to provide the same advantages of low-cost, high-quality and broad diversification to bond fund investors that the Vanguard 500 provided to equity fund investors. Early in 1994, without much enthusiasm from his associates, Bogle inaugurated three additional bond portfolios—short term, intermediate term and long term—based on the appropriate Lehman indexes. The three new portfolios, like the original all-market bond portfolio, met with modest early acceptance but gradually became increasingly popular. As of October 2010, the Total Bond Market Index Fund had $89 billion in it, making it one of Vanguard's most popular funds.

Although Fidelity and Dreyfus funds joined the indexing fray in the 1980s, more out of expediency than out of desire, Vanguard faced no real competition from them in this area because they weren't really interested in selling such low-margin products. But gradually some other players that initially had flown beneath the radar emerged as a genuine threat to Vanguard's index fund dominance.

Perhaps it should come as no surprise that some of the same academics involved with the foundations of efficient market theory helped create Vanguard's first real competitors. One of the earliest was Dimensional Fund Advisors (DFA), which is based in Austin, Texas. Its founders, University of Chicago MBA graduates David Booth and Rex Sinquefield, were indexing even before Vanguard, because Booth and Sinquefield worked, respectively, at Wells Fargo and American National Bank of Chicago on their institutional index accounts in the early 1970s. Together they launched DFA in 1981, providing indexlike offerings with low expenses not to individual investors, but to financial advisors and institutions. Other efficient market "luminaries" such as Eugene Fama and Kenneth French soon joined DFA's board of directors.

DFA's approach to indexing differed from Vanguard's in that DFA wasn't afraid to venture into lesser-known, riskier areas of the securities markets such as micro-cap stocks and Japanese small-cap stocks. Its oldest fund, DFA U.S. Micro Cap, was launched in 1981. The firm was also not such a purist when it came to indexing, since it would sometimes tweak published benchmarks to gain an edge, tilting them more toward a valuation-driven model. Or it would create its own in-house indexes that it saw as superior to published ones. It also developed a proprietary trading system to minimize transaction costs. Although the value ($8.3 billion) of its largest fund, DFA Emerging Markets, is dwarfed by Vanguard's heavy hitters, its low-cost index philosophy was inspired by the same spirit of modern portfolio theory as Vanguard's, and many of its funds have proven highly competitive with Vanguard's best.

A far more significant threat emerged from State Street Global Advisors and Barclays Global Investors in the form of exchange-traded funds (ETFs). These two money managers had already become fierce competitors in the institutional investor space for indexed assets in the 1980s and 1990s. For instance, total assets under management at State Street grew from $38 billion in 1988 to $142 billion by the end of 1993, and much of that institutional money was in passively managed indexed strategies. But then in 1993, State Street fired a broadside at Vanguard's retail business by launching the first ETF in the United States, the Standard & Poor's Depositary Receipt, or the SPDR S&P 500 ETF, as it came to be called. The ETF followed the same benchmark as the Vanguard 500 fund, but it was tradable all day long like a stock and therefore was easily accessible to individual investors. What's more, the management fees were competitive with Vanguard's. In fact, by March 2000, State Street had reduced the SPDR S&P 500's expense ratio to 0.12 percent, which was less than the Vanguard 500's 0.18 percent for individual investors at the time. By then the ETF had already attracted some $17.3 billion in assets.

It wasn't long before Barclays also entered the arena. The same division of wonky efficient market enthusiasts at Wells Fargo Bank that created the first institutional index account in 1971 was eventually acquired by Britain's Barclays Bank for $440 million in 1995 to become Barclays Global Investors. In the meantime, Barclays had already become an institutional indexing powerhouse. In 1996, it collaborated with Morgan Stanley to launch its World Equity Benchmark Shares, or WEBS, brand of index ETFs that tracked various international markets such as those of France, Italy and Japan. These were later rebranded as iShares in May 2000, which was about the same time that Barclays started to aggressively launch other ETFs that tracked U.S. benchmarks similar to Vanguard's. By the market's peak in 2000, Barclays was already managing $800 billion worldwide, primarily in institutional assets, but the storm clouds were brewing.

At the time, Vanguard officially claimed that it didn't see ETFs as much of a threat. "To me it's effectively a product extension like instant coffee," said Vanguard spokesman Brian Mattes in March 2000, just as Barclays was preparing for a major rollout of new ETFs. "When instant coffee debuted, did it really hurt the sales of brewed coffee? No. People still liked brewed coffee. But it put coffee in the hands of people who couldn't wait for it to percolate."4 But behind the scenes, the pressure was mounting. Indeed, although index funds had grown from 9 percent of total equity fund assets in 1999 to 17 percent by 2007, 7 percentage points of that number were from index ETFs. Without ETFs, the index mutual fund market share would have grown to only 10 percent.


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