Index Funds Have Officially Won

This
revolution
occurred
only
gradually.
Vanguard
introduced
the
first
publicly-available
index
fund
back
in
1976
(Wells
Fargo
already
offered
a
version
for
its
institutional
clients).

A
private
railroad
car
is
not
an
acquired
taste, quipped the
English
actress
Eleanor
Robson
Belmont.
However,
index
funds
certainly
were.
20
years
later,
fund
shareholders
barely
noticed
their
existence.
Actively-run
equity
funds
held
far
more
assets
than
did
indexed
stock
funds.
And
there
were
no
passively-managed
bond
or
allocation
funds.

Warning
Signs

But
for
active
management,
ill
omens
lurked.
Although
retail
buyers
cared
little
for
indexing,
by
the
mid-90s
the
strategy
had
become
the
rage
among
institutional
investors.

What’s
more,
Vanguard
500
Index’s
[VFINX] 20-year
returns
were
appealing.
Before
long,
the
marketplace
would
notice
that
fund’s
success.
In
fact,
I
ventured
at
the
time,
indexing
might
someday
account
for
as
much
as
(gasp)
30%
of
the
fund
industry’s
assets.

So
much
for
brash
predictions.
(And
it
was
considered
very
brash
at
the
time,
earning
a
pull
quote
in
a
magazine
article.)
Not
only
did
index
fund
assets
exceed
the
30%
level
in
2015,
but
their
market-share
growth
has
accelerated
since
then.
Almost
certainly,
they
will
crack
the
70%
mark
during
the
next
decade.

(Note:
although
the
chart
shows
active
funds
still
clinging
to
a
tiny
lead,
passive
funds
did
indeed
surpass
them
shortly
after
the
new
year.
However,
the
official
January
numbers
were
unavailable
when
I
prepared
this
article.)

Implications

For
the
most
part,
the
public
discussion
of
indexing’s
ascension
has
been
unhelpful.
The
prevailing
argument –
that
indexing’s
success
has
distorted
stock
market
prices –
is
both
unprovable
and
improbable.
The
second
claim
is
that
a
handful
of
index
fund
providers
control
too
many
assets.
Perhaps
that
is
so,
but
what
specific
threat
do
they
pose?
At
this
stage,
that
concern
is
preliminary.
Meanwhile,
few
outside
the
occupation
itself
have
commented
on
an
actual
and
profound
outcome:
indexing’s
impact
on
financial
advice.

The
Stock
Market

Over
the
years,
investment
managers
have
often
complained
indexing’s
boom
has
destabilised
equity
prices.
Unfortunately
for
the
credibility
of
such
objections,
they
predate
indexing’s
triumph.
When
I
joined
Morningstar
in
1988,
portfolio
managers
frequently
told
me
that
their
funds’
disappointing
returns
were
due
to
“market
irrationality”.
At
that
time,
the
culprit
was
“the
herd” –
which
sometimes
meant
uninformed
retail
investors
and
other
times
trend-following
fund
managers –
rather
than
indexing.
But
the
line
of
thought
was
the
same.

At
any
rate,
the
argument
deconstructs
itself.

If
indexing
has
made
the
stock
market
less
rational,
that
change
should
represent
an opportunity for
active
fund
managers,
rather
than
an
obstacle.
After
all,
they
have
no
role
to
play
if
equity
valuations
are
fully
rational.
They
are
only
useful
if
stocks
are
somehow
mispriced.
By
this
claim,
then,
indexing
has
improved
active
managers’
situations.

Regrettably,
it
has
not.
Although
indexing
has
become
far
more
popular
than
in
the
past,
tens
of
trillions
of
dollars
remain
in
the
hands
of
active
investors,
including
a
record
number
of Chartered
Financial
Analysts.
Also,
technology
has
enabled
a
higher
level
of
investment
research,
by
more
parties,
than
ever
before.
To
be
sure,
indexing
at
some
point
could
become
so
prevalent
as
to
disrupt
stock
prices.
Not
yet,
though.

Too
Powerful?

The
second
critique –
that
the
leading
index
fund
providers
have
become
too
dominant –
is
more
substantial.
Unlike
the
previous
assertion,
it
is
not
old
wine
repackaged
in
a
new
bottle.
Portfolio
managers
have
carped
since
Caesar
crossed
the
Rubicon
about
how
the
markets’
foolishness
caused
them
to
underperform.
But
not
in
US
history
have
so
few
controlled
so
much
money,
possessed
by
so
many.
The
percentage
of
US
equities
held
by
the
leading
index
fund
providers
(in
particular
Vanguard
and
BlackRock
[BLK])
is
unprecedented.
We
have
not
been
here
before.

Second,
Jack
Bogle
himself advanced
the
thesis.
It’s
one
thing
for
active
managers
to
attack
their
highly-successful
rivals
and
quite
another
for
the
criticism
of
indexing
to
come
from
the
strategy’s
chief
proponent.
The
issue
deserves
its
due.

The
difficulty,
as
Bogle
conceded,
is
that,
at
least
for
now,
the
objection
is
theoretical.
It
seems
unwise
to
permit
a
handful
of
companies
to
hold
a
large
minority
of
US
equities.

What,
however,
is
the
practical
danger?
The
closest
that
anybody
has
come
to
identifying
a
problem
has
been
an
argument
that
index
fund
providers are
too
soft on
corporate
managers,
but
that
allegation
is
difficult
to
prove.
Also,
most
shareholders
vote
as
chief
executives
desire.
If
corporate
managements
are
permitted
too
much
leeway,
index
funds
are
scarcely
the
only
reason.

Financial
Advice

As
my
colleague
Syl
Flood
reminds
me,
indexing
has
most
substantially
affected
the
financial
advice
industry.
The
growth
of
indexing
forced
a
business
that
had
primarily
marketed
itself
for
its
expertise
in
investment
selection –
first
equities,
then
funds –
to
reinvent
itself.
Not
all
advisers
were
pleased.
Over
the
years,
dozens
of
financial
advisers
fretted
to
me
about
the
possibility
that
indexing
would
ruin
their
business,
because
if
they
couldn’t
offer
their
customers
something
better
than
the
obvious
investments,
who
would
need
their
services?

A
whole
lot
of
people,
as
it
turned
out.
The
financial
advice
industry
hasn’t
skipped
a
beat.

Today,
as
then,
most
older
investors
who
have
accumulated
substantial
assets
seek
professional
help.
The
industry’s
continued
success
demonstrated
that
what
investors
truly
needed
was
not
better
funds.
(Although
with
low-cost
index
funds,
they
usually
got
them.)
They
needed
better service.
They
needed
advisers
who
thought
more
about
their
needs
and
less
about
products.
They
needed
advisers
who
devoted
more
time
to
their
goals,
risk
tolerances,
and
tax
situations.

The
financial
advice
world
has
obliged.
Not
entirely,
of
course.
Progress
is
inevitably
fitful.
But
I
am
confident
in
stating
that
today’s
financial
advisors
are,
on
average,
superior
to
those
I
first
met
35
years
ago.
Index
funds
played
a
critical
role
in
the
industry’s
improvement.
They
helped
both
adviser
and
client
to
appreciate
what
was
truly
important.

Future
Implications

This
experience,
I
believe,
will
be
repeated
with
artificial
intelligence
(AI).
Quite
naturally,
many
financial
advisers
are
worried
that
they
will
be
replaced
by
AI
routines.
But
that
fate
seems
to
me
unlikely.

Just
as
advisers
adapted
to
index
funds’
dominance
by
redefining
their
roles,
so
will
they
evolve
in
response
to
AI.
The
tools
have
become
cheaper
(index
funds)
and
ever
more
sophisticated
(AI
programmes).
In
the
end,
though,
they
are
just
that:
tools.

That
strikes
me
as
a
lesson
for
every
occupation.
It’s
too
late
for
me
to
redefine
my
career,
nor
do
my
finances
require
me
to
do
so.
Were
I
40
years
younger,
though,
I
know
how
I
would
proceed.
I
would
not
be
concerned
with
obtaining
specific
knowledge.
Whatever
I
learned,
AI
could
mimic
in
a
microsecond.
Rather,
I
would
think
very
long
and
very
hard
about
what
expertise
I
could
develop
that
an
AI
program
could
not;
how
might
I
feed
on
AI,
so
that
it
would
not
feed
on
me?

A
bit
far
afield
from
this
article’s
original
topic,
I
realise.
But
if
there’s
one
thing
that
indexing’s
victory
demonstrated,
it
is
that
revolutions
have
consequences.
Better
to
anticipate
the
changes
such
disruptions
create
than
to
chase
them.

John
Rekenthaler
is
vice
president
for
research
at
Morningstar

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