Index Funds Shine Bright Despite Critics Throwing Shade

When the index fund made it debut almost a half-century ago, it wasn't welcomed with fanfare and open arms. It was a slow burn. But one that turned into a raging fire with no signs of being contained...even though there have been more than a few critics along the way throwing buckets of water on the inferno.

Will it stand the test of time? Let's take a look back and see how it translates to today's world.

The Match Strikes

As with many innovative developments, the early days of the index fund phenomenon happened with little fanfare. In late summer 1976, John Bogle, Vanguard’s founder, introduced the index fund to individual investors. True, a few rare institutional investors – mostly Wells Fargo clients – were already aware of the intriguing concept, but a couple more decades passed during which these so-called “unmanaged” funds were barely discussed in polite circles as viable investment tools by a wary group of staunch critics - equity fund advisors.

Prior to 2000, largely due to the shunning of index funds by the industry’s investment advisors, small investors showed little interest in index funds –– although their institutional sidekicks had adopted the index strategy in a significant way. The institutional crowd had long noted the studies showing that the Vanguard 500 Index’s two decades of returns were attractive due to risk reduction (diversification), low costs and routine outperformance of managed funds. With these increasingly obvious advantages versus long-practiced trading strategies, the small investor market began to explode.

The Flame Ignites

As the 2000 millennium approached, “managed” equity funds held far more assets than did this new indexing effort. The truth about index funds had finally captured the attention of the average investor. But skeptics were quick to dampen this newfound enthusiasm.

“Why settle for a simple market rate of return,” yelped the scornful critics, “when an often irrational equity landscape offered so many more profit opportunities?”

However, money talks and things dramatically changed during the early years of the 21st Century. Individual investors started paying attention to these highly diversified, low-cost, dare to be average funds as study after study revealed their simplicity and worth. After 2000, the index fund market exceeded the 30% mark by 2015 – only to gather more steam.

As the 2020s rolled around, these passively managed funds (includes both traditional mutual funds and exchange-traded funds ETFs) quietly gathered more assets than their actively managed counterparts.

Proponents of indexing predict it will surpass the 70% mark during the next decade.

Bucket Brigade

The extreme popularity of indexing catalyzed a new band of critics who claim that its booming success has and will increasingly distort stock market prices. Concrete evidence of that phenomenon, at this point, seems lacking documentation.

Others claim that a handful of index-fund providers control too many assets, among them Bogle’s now gigantic Vanguard. Perhaps, but what specific threat does Vanguard and its ilk pose? Perhaps the threat will be more obvious when indexing reaches 70% of the equities market.

Predictably, there has indeed been a major and measurable impact on the quick to criticize financial-advisory group. This prescient crowd recognized early on the freight train headed their way – and the impact it would have on their fees. Not surprisingly, these were the same folks who had fought the indexing movement since day one.

During those early years, before indexing gained the upper hand, investment managers and advisors were already preaching that index funds were price destabilizers…a handy excuse for their own disappointing returns relative to indexing performance. But more likely it was an early excuse to avoid “daring to be average." Understandable resistance, of course, because their very livelihoods were at stake. The admission that unmanaged index funds could consistently outperform funds managed by a well-schooled team of experts was hard to accept.

For several decades this broad consensus that their disappointing yields relative to index funds was due to “market irrationality” did in fact impede the early acceptance of index funds despite the indexers’ superior performance. Yup, they insisted, market irrationality was the problem; an irrationality that led to herds of retail investors stampeding for the exits at the first sign of a troubled market (encouraged by copycat investment managers with similar herd-like tendencies in their own ranks).

Missed Opportunities

But doesn’t common sense suggest that, instead of hurdles, irrational markets would create opportunities for active fund managers? By definition, a rational market is one that’s rationally priced, leaving not more but less opportunity for active managers to locate and take advantage of mispriced stocks. In short, if the argument holds that indexing creates market irrationality, wouldn’t by definition indexing enhance an active manager’s environment for greater profit opportunity, not less?

Yet, portfolio managers have raged on about how market foolishness causes them to underperform. Despite this sentiment - and though indexing is far more popular today than pre-2000 - literally trillions of dollars still reside with active managers.

Why?

Undeniably, advanced technology has contributed to a higher level of investment research in industry (and by individuals), but the results are much the same. Indexers consistently outperform managed funds over time allowing vastly more individual investors to outperform many of their trading counterparts simply by daring to be average.

Like Mr. Bogle said,

“Don’t look for the needle in the haystack, buy the haystack.”

In short, accept the market rate of return and keep smiling.

Potential Wildfire?

The concern that certain leading index-fund providers have become too dominant might hold some water. Never before have so few controlled so much, possessed by so many. At the peak of this pyramid of index-fund providers is Bogle’s Vanguard and the mammoth BlackRock. This criticism is new ground…not plowed before. It's to be expected that active managers would attack their successful unmanaged rivals. It’s quite another for criticism of indexing to come from the strategy’s chief proponents.

But the issue, although at this time theoretical, warrants consideration. Is it threatening to the system that a handful of powerful index fund companies – Vanguard, Blackrock, State Street – hold a significant minority of U.S. equities?

Case in point:

• These three giants manage well over $23 trillion, much of it passive funds.

• Vanguard and Blackrock each hold more than 10% of shares of many banks (usually determined as a controlling interest in a lender).

It's not a problem for regulators as long as the big firms remain passive. So what, exactly, is the danger? Critics have long suggested that index-fund providers are too easy on corporate managers. Perhaps, but as a longtime voting shareholder, my experience has been that most shareholders vote the way CEOs suggest. Still, it’s food for thought.

Disruptive Transformation

As an early indexer who quickly abandoned the use of services provided by the financial-advice folks, my quick historical review suggests that indexing substantially impacted the advice givers. It forced self-promoters of expertise in investment picking – individual stocks and later funds – to reinvent themselves. They had to. If they couldn’t offer small investors something better than those obviously highly diversified, low-cost, quality investments, who would seek their services?

Good question, but apparently, a lot of folks still do. Older investors, including many who’ve adopted indexing as the beating heart of their portfolios, often continue to seek the help and comfort of these financial professionals. Today’s advisers traditionally assess annual fees, usually between 0.75% and 1.25% of the client’s investment portfolio. I can’t lose the nagging fear that an advisor’s financial advice might be influenced by his or her own income considerations, steering clients away from decisions that reduce an investor’s net worth subject to fee-based calculations.

Case in point, an old standard was to advise clients to enter the retirement years debt free (i.e., without a mortgage), or to take social security early versus selling equities to cover a healthy portion of living expenses versus the option of selling fee-exposed portions of a portfolio. Such examples abound. A fee-based structure is full of temptations for advisers to make recommendations to keep a portfolio balance as large as possible, even when it’s not in a client’s best interest.

The financial gurus’ continued presence suggests that what seasoned investors need are not just better funds. They’ve got those – low-cost index funds and a plethora of other, high-quality managed options. But they obviously yearn for something more…a friendly advisor capable of devoting attention to their goals, their fluctuating tolerance for risk, their expertise in dealing with the complexities of taxes. In short, they seek personal service and advice on product selection.

That suggests to me that the rise in popularity and success of indexing played an important role in the improvement of services in the personal finance industry; that it gave both advisors and potential clients a newfound appreciation of what was truly important. And it’s more than just yield.

As Daniel Kahneman, noted Princeton University psychologist and winner of the Nobel Prize in economics (who by the way didn’t try to outsmart the market but invested mostly in index funds), was quoted as saying,

“The idea that I see what no one else can is an illusion. All of us would be better investors if we just made fewer decisions.”

Buy and hold comes to mind.

New Competition

And yet a new worry has reared its ugly head in the financial advisor and other communities… artificial intelligence, or Al. Will advisors of all sorts be replaced by these mushrooming, increasingly sophisticated Al routines that have so men and women of various expertise fretting about their futures?

Indexing pointed out an important fact: Humankind is extremely adaptable. And just as investment advisors redefined their roles while adapting to index funds’ enhanced returns and decreased costs of service, I suspect advisors of all sorts will similarly evolve in response to Al.

In Sum

Index funds and Al programs are simply tools, ever more efficient, cheaper and sophisticated. Like the wheel, the printing press, the steam engine, the computer and iPhones that preceded them, change is a constant…and disruptive…and disruption has consequences. Seems to me it’s better to anticipate and roll with the changes that disruptions create than to chase after them.