Passive investing has been ridiculed by Wall Street for decades. But I think it is safe to say that Sanford C. Bernstein & Co. strategist Inigo Fraser-Jenkins and his research team have set a new standard with their recent note, “The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism.”
In the note, Fraser-Jenkins and his team warn policymakers that index funds might grow to the point at which new investments could be massively mispriced. They write: “A supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management.” Let’s look at whether we should be worried about this issue.
Whose Interest Do They Have at Heart?
As American novelist Upton Sinclair wrote, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” The tidal wave that is the trend to indexing and passive investing in general has certainly created what could be called an existential threat to the active management industry, which explains why it has always railed against it.
With that in mind, I thought it worthwhile to begin our discussion with a brief review of the history of passive investing and the criticisms of it from Wall Street.
John Bogle graduated from Princeton in 1951. His senior thesis was titled: “The Economic Role of the Investment Company.” Bogle later wrote that his inspiration for starting an index fund came from three sources, all of which confirmed his 1951 research: Paul Samuelson’s 1974 paper, “Challenge to Judgment”; Charles Ellis’ 1975 study, “The Loser’s Game”; and Al Ehrbar's 1975 Fortune magazine article on indexing.
In 1974, Bogle founded The Vanguard Group, now the largest mutual fund company in the United States. He started the First Index Investment Trust, later renamed the Vanguard 500 Index Fund, in December 1975. The following June, a very prescient story appeared in Fortune: “Index Funds: An Idea Whose Time Is Coming.” It concluded: “Index funds now threaten to reshape the entire world of money management.”
Philosopher Arthur Schopenhauer once said that all great ideas go through three stages. In the first stage, they are ridiculed. In the second stage, they are strongly opposed. In the third stage, they are considered to be self-evident.
This was certainly the case for Bogle’s experiment. When it was launched, his index fund was heavily derided by the mutual fund industry. The fund was even described as “un-American,” and it inspired a widely circulated poster showing Uncle Sam calling on the world to “Help Stamp Out Index Funds.”
The fund was also lampooned as “Bogle’s Folly.” Fidelity’s chairman, Edward Johnson, assured the world that his company had no intention of following Bogle into index funds when he stated: “I can’t believe that the great mass of investors are going to be satisfied with receiving just average returns. The name of the game is to be the best.”
And another fund manager, National Securities and Research Corp., categorically rejected the idea of settling for average. “Who wants to be operated on by an average surgeon?” they asked.