Wednesday marked the fortieth birthday of the most investor-friendly idea in stock market history: the index fund. Forty years ago Vanguard introduced the first fund that merely tracked the S&P 500. It has appreciated 6,334 percent since inception, trailing the S&P by a mere .14 percent annually, all of which was the ‘expense ratio’ charged investors. Few, if any other funds have matched or exceeded this annual return.
Today roughly $5 trillion is invested in index funds. Vanguard is the largest index manager, with over $3 trillion in assets under management (AUM). Other money managers now offer index products alongside their traditional, actively managed funds.
Study after academic study shows that index funds outperform most actively managed funds. The reason is simple. Fees. The average expense ratio for actively managed stock funds is around 1.5 percent. It is somewhat less for fixed income funds. As Vanguard founder John Bogle has convincingly shown, a fund with a 1.5 percent annual fee (and the same pre-fee annual return) will produce a much smaller total return over a multi-year period than a fund with a .14 percent annual fee.
Investors have taken notice. According to the Wall Street Journal, they have invested $409 billion in passive index funds in the last year and pulled $310 billion out of actively managed funds over the same period. Roughly 20 percent of all money in stock funds is now indexed, up from zero 40 years ago.
I suspect this trend will accelerate.
After one of the craziest rides anyone can remember, with the Dow dropping over 1000 points in a session for the first time and everybody learning the definition of “Rule 48,” stocks ended up pretty much where they began last week. Incredibly, the Dow, S&P and Nasdaq were actually up modestly by Friday’s close. Besides Xanax manufacturers, there were two clear winners in all of the sound and fury signifying not very much: the market’s croupiers—the brokers and Wall Street traders who collect commissions on stocks, bonds, and other financial products—and Mr. John Clifton Bogle.
As a Princeton graduate student in the 1970s, Bogle invented the index fund. Today almost 1/3rd of all mutual fund assets are invested in index funds and Bogle’s Vanguard Group is the nation’s largest money management firm as measured by assets under management. Study after academic study shows that the S&P 500 has produced an 8.5 percent annual return since World War II, while the average actively-managed mutual fund has delivered about 7 percent (after deducting the 1.5 percent average “expense ratio”). The typical retail investor lags far behind, earning closer to 5 percent a year. Weeks like this past one are a big reason why.
We are definitely living through the financial equivalent of the steroids era on Wall Street, with celebrity fund managers jacking up their assets under management and posting (allegedly) too-good-to-be-true returns. But beyond the ego-driven corruption of places like Manhattan and Greenwich, there are hopeful signs that things might be getting better in my industry. Not surprisingly, two of the best examples of this trend come from a place regular readers of this blog know I am quite fond of: Texas.