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.
The Vanguard 500 Changes Everything
The Vanguard 500 Index Fund (VFINX) began with comparatively meager assets of $11 million, but crossed the $100 billion milestone in November 1999. Today VFINX has more than $250 billion in assets, the similar Vanguard Total Stock Market Fund (VTSMX) has more than $450 billion in assets, its Total Bond Market Index Fund (VBMFX) has more than $170 billion in assets and its Total International Stock Index Fund (VGTSX) has almost $220 billion in assets. Just these four funds alone have more than $1 trillion in assets under management.
The success of “Bogle’s Folly” demonstrates the wisdom of Victor Hugo’s statement: “There is one thing stronger than all the armies in the world, and that is an idea whose time has come.” In one of the great ironies, Fidelity (with the same chairman, Edward Johnson) is now one of the market’s largest providers of index funds—if you can’t beat them, join them.
The ultimate success of index funds was virtually inevitable. It was simply a matter of time. In his December 2003 column, “Also Stalking the Fund Industry: Obsolescence,” Holman Jenkins Jr. of The Wall Street Journal made the following observations: “Will fund customers keep supporting the enormous overhead required to sustain ineffectual, unproductive stock picking across an array of thousands of individual funds devoted to every ‘investing’ style and economic sector or regional subgroup that some marketing idiot can dream up? Not likely. A brutal shakeout is coming and one of its revelations will be that stock picking is a grossly overrated piece of the puzzle, that cost control is what distinguishes a competitive firm from an uncompetitive one.”
David Swensen, Chief Investment Officer of the Yale Endowment Fund, offered the following insight: “Thievery, even when dressed in the cloak of SEC-approved governance, remains thievery ... as the powerful financial services industry exploits vulnerable individual investors.” When challenged by The Wall Street Journal that his conclusions were “pretty harsh,” Swensen replied, “The evidence is there.”
With all this said, there remains an important message inside the note from the Sanford C. Bernstein & Co. strategists.
The Benefits Provided By Active Investors
Active managers do play an important societal role. Specifically, their actions determine security prices, which in turn determine how capital is allocated. And it is the competition for information that keeps markets highly efficient, both in terms of information and capital allocation.
Passive investors are “free riders.” They receive all the benefits from the role that active managers play in making the financial markets efficient without having to pay their costs. In other words, while the prudent strategy is to be a passive investor, you don’t want everyone to draw that conclusion. Passive investors need hope to spring eternal for those still convinced active management is the winning strategy.
However, there’s also the question of the costs that accompany the societal benefits that active managers provide.
The Cost Of Active Management
Kenneth French sought to address that important issue in his 2008 study, “The Cost of Active Investing.” His study covered the period 1980 through 2006, and included mutual funds, ETFs, hedge funds and institutional funds.
By comparing the fees, expenses and trading costs that society pays to invest in the U.S. stock market with an estimate of what it would pay if everyone invested passively, French found that investors spent 0.67% of the market’s aggregate value each year searching for superior returns.
French concluded that active investors are engaged in a massive transfer of wealth (about $80 billion annually, based on a market capitalization at the time of about $12 trillion) from their own wallets and into the hands of the purveyors of actively managed products and their market makers. That figure is almost certainly higher today, as total U.S. market capitalization is now about $20 trillion.
Is It Worth The Costs?
Given that, each year, the active management industry likely transfers more than $100 billion in funds out of the wallets of investors, it’s not hard to make the case that investors and the country as a whole would be better off if much, but not all, of the industry disappeared.
As my co-author, Andrew Berkin, and I point out in our book, “The Incredible Shrinking Alpha,” the percentage of active managers able to generate statistically significant alpha has fallen from about 20% 20 years ago to just 2% today. One of the reasons for this drop is that the competition has gotten tougher over time.
For example, Charles Ellis, one of the most respected people in the investment industry, noted the following. He wrote that “over the past 50 years, increasing numbers of highly talented young investment professionals have entered the competition … They have more-advanced training than their predecessors, better analytical tools, and faster access to more information.”
Legendary hedge funds, such as Renaissance Technology, SAC Capital Advisors and D.E. Shaw, hire Ph.D. scientists, mathematicians and computer scientists. MBAs from top schools, such as the University of Chicago, Wharton and MIT, flock to investment management armed with powerful computers and massive databases.
Ellis went on to observe that the unsurprising result of this growth in skill level is that “the increasing efficiency of modern stock markets makes it harder to match them and much harder to beat them, particularly after covering costs and fees.”
The inevitable trend is that the weaker, less-skilled competitors—both individual investors and institutions—are abandoning the game of active management. That should help make markets more efficient, not less, as the more skilled managers are less likely to make the many behavioral mistakes that naive retail investors and less sophisticated institutional investors commit. Such mistakes lead to mispricings, like the tech bubble that eventually burst in the early 2000s.
Academic literature is filled with evidence of mispricing anomalies caused by investor overconfidence and behavioral biases. Obviously, this could be taken to the extreme, in which everyone would be a passive investor and there was no price discovery activity.
However, we’re a very long way from that. Despite their growing share of the market (passive funds now control perhaps one-third of all assets under management), they still account for only a small percentage of trading activity. According to a Vanguard spokesman, on a typical day, only 5-10% of total trading volume comes from index funds.
Still Plenty Of Active Management
There is still plenty of room for active funds to set prices. My guess is that at least 90% of the active management industry could disappear and the markets would remain highly efficient. Remember, the markets were doing a pretty good job of allocating capital long before the hedge fund industry started to become an important factor about 20 years ago.
It wasn’t until 1950 when the number of mutual funds topped 100. That number was still only at about 150 in 1960. And we didn’t seem to have any problems allocating capital efficiently then.
Today we have more than 9,000 mutual funds and probably more than 10,000 hedge funds. Do investors really need all those active managers to ensure that capital is allocated efficiently? It doesn’t seem likely.
There is one other point to make. At least as of today, the fact that companies who report better- or worse-than-expected results still see higher volumes and larger same-day price moves implies that there are still plenty of investors making the markets highly efficient.
I’ll close with a final caution: Keep all of this to yourself, and enjoy the benefits of being a free rider, without any of the costs. We don’t want everyone to abandon the quest for alpha.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.