HOORAY FOR INDEX FUNDS -- JUST DON`T CALL THEM PASSIVE / THE ECONOMIST

Hooray for index funds—just don’t call them passive

Jack Bogle’s creation has transformed markets, and involves plenty of choices

Illustration: Satoshi Kambayashi

The launch of the Vanguard First Index Investment Trust, 50 years ago this month, could have gone better. 

Jack Bogle, Vanguard’s founder, called it “an abject failure”. 

He had hoped to raise somewhere between $50m and $150m, but got only a little over $11m ($65m today). 

As the first fund aiming to do no more than track a stock-market index—America’s S&P 500—that was available to individual investors, it nevertheless raised hackles. 

“One conclusion, usually expressed with considerable feeling, is that index funds are a ‘cop-out’ and a fad that will soon disappear,” sniffed an article in the Financial Analysts Journal, published later the same year.

Half a century on, there is no sign of that. 

Over 50% of net assets overseen by American investment funds are in trackers, estimates the Investment Company Institute, an industry group. 

For funds focused on domestic stocks, the share is 64%. 

Whether through your own savings, a corporate pension scheme or a university endowment, you probably have a stake in at least one.

Predictably, the professional stock-pickers whose lunch has been eaten are as furious as ever. 

“Worse than Marxism,” thundered Bernstein, a broker, in 2016. 

Last month Terry Smith, a favourite fund manager of British retail savers, spent much of his half-yearly investor letter blaming his long underperformance on “a market which is dominated by so-called passive or index funds”. 

Full disclosure: your columnist, who used to own units in one of Mr Smith’s funds, took this rant as his cue to sell them and reinvest in a global-equity tracker.

On one count, however, Mr Smith is right. 

Bogle’s creation ranks among the most important financial innovations of the 20th century, and deserves its place in most investors’ portfolios. 

Yet the idea that index funds are passive is bunk. 

Over the past five decades these vehicles have reshaped markets—and investing in one involves plenty of choices.

The most obvious decision is which index to track. 

Suppose you want exposure to European shares. 

Should you choose 50 of the biggest firms via the STOXX Europe 50 index or 396 via the MSCI Europe?

Plenty of people “passively” invest in America’s stock-market by tracking the NASDAQ 100, a tech-focused bet that ignores whole sectors such as finance and real estate.

Even if you opt for an index like the FTSE Global All-Cap, which captures over 10,000 firms across the whole world, why stop there? 

To a purist, true passivity entails buying the “market portfolio”, meaning an impractical one including all investible assets, from private credit and property to art and fine wine. 

A 60/40 split between a stock tracker and a bond tracker is an active decision (why 60/40?)—and a big one at that.

Index funds themselves are not passive, either. 

Rodney Comegys, Vanguard’s head of equities, explains that managers have more discretion than many investors realise. 

At its launch, for instance, the First Index fund was too small to buy every share in the S&P 500. 

So it “sampled” 300 or so of them, a practice others still use today. 

Managers can also trade to minimise taxable gains, or to avoid getting screwed when everyone knows they must rebalance (when a firm such as SpaceX joins an index, say). 

Some juice returns by lending stocks to short-sellers for fees.

Most important, and worrying, index funds seem increasingly to influence asset prices. 

This is not just because they are so big. 

Prices are set by trades, and slow-trading trackers, even enormous ones, account for a tiny fraction of these. 

But a series of studies have suggested they nevertheless cause distortions. 

A particularly widely circulated one outlines the “inelastic markets hypothesis”. 

This finds evidence that the presence of fixed-allocation funds (such as trackers investing all their assets in shares) ensures $1 flowing into the stock-market pushes up overall market value by $3-8. 

Others have argued that flows into index funds disproportionately raise the share prices of the biggest firms.

Perhaps, then, the popularity of index funds is storing up trouble, helping to inflate a stock-market bubble while also entrenching the dominance of a few corporate giants. 

Ironically, even that would not be an argument to divest. 

When share prices next crash, just as when they soar, trackers will clock their average—doing better than the average stock-picker, who will get the same return minus heftier fees. 

In 50 years’ time, it is a good bet that index funds will be mightier yet.