Trillions Book Review

Big investment funds have a public face, a famous money manager who is constantly “talking up his fund” on financial television shows. By contrast, index fund investing is hard to comprehend.

The Financial Times journalist Robin Wigglesworth got curious about those “missing faces” and wrote a fascinating history of how indexing got started. The resulting book is called Trillions, because that’s how much money lowly index funds have come to manage over the years for millions of everyday investors.

Rebalance’s Investment Committee member Professor Burton Malkiel recently wrote a compelling review of Trillions in The Wall Street Journal.

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‘Trillions’ Review: The Rise and Rise of the Index Fund

When John Bogle wanted to move investment into portfolios managed by formula, he was ridiculed in the press. Nobody’s laughing now.

By Burton G. Malkiel

Index funds—which buy and hold all the stocks in an index, such as the S&P 500—now account for more than 40% of the money invested in mutual funds and exchange-traded funds. Literally trillions of investment dollars are currently indexed. Hence “Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever,” a chronicle of financial innovation by Robin Wigglesworth, a correspondent for the Financial Times. “Trillions” is a magisterial, delightfully written history offering up portraits of the academic scribblers and entrepreneurial practitioners who created the index-fund revolution. It also contains common-sense wisdom that will benefit all investors.

Indexing has so demonstrated its effectiveness that Warren Buffett has directed that his estate be invested mainly in index funds. Several years ago, he handily won a million-dollar bet that an index fund could beat a curated selection of five hedge funds. As Mr. Wigglesworth shows, today’s popularity contrasts dramatically with the skepticism that first greeted the idea. With consummate skill, he brings to life the eggheads and the “iconoclastic” investors who guided indexing through its difficult birth pangs and oversaw its exponential development. He turns an arcane and potentially dull tale into a rip-roaring yarn.

Some of the most important figures in the index revolution were, as Mr. Wigglesworth writes, “inconsequential in their own time.” None was more underappreciated than the French mathematician Louis Bachelier (1870-1946). He was the first to suggest that stock prices proceeded like a “random walk”—where prices proceed in a random and unpredictable fashion. Though he died in obscurity, his “Theory of Speculation” is viewed as one of the seminal works in the history of finance.

The names of some of the other figures are better known, and three are Nobel laureates. Harry Markowitz’s ground-breaking 1952 Ph.D. thesis at the University of Chicago—“Portfolio Selection,” in which stocks were analyzed in terms of their contributions to the riskiness of the overall portfolio rather than of their individual prospects—was almost rejected because Milton Friedman initially argued that it wasn’t economics. William Sharpe, Mr. Wigglesworth tells us, switched from medicine to economics because he became queasy at the sight of blood. He ended up simplifying the Markowitz model and made it more tractable by stipulating that market return—the broad performance of a vast grouping of stocks—was the major influence on portfolio returns. Thanks to Sharpe’s analysis, “beta”—or relative volatility, measuring a stock’s variations against a benchmark—was born as a risk metric. After early doubts it became widely used in actual practice.

Eugene Fama was a small, slim high-school athlete who claims to have invented the split-end position in football to avoid the beatings that he sustained trying to block much larger opponents. Mr. Fama articulated the controversial “Efficient Market Hypothesis” that provides intellectual justification for indexing. He also showed that security returns were influenced by other factors in addition to Sharpe’s beta, an insight that led to the establishment of Dimensional Fund Advisors, a set of funds that uses measures such as “value,” “size” and “quality” to form portfolios.

The first index fund was created in the early 1970s by “bullheaded” John (Mac) McQuown at Wells Fargo bank. The idea of indexing drew widespread criticism, including condemnation from Wells Fargo’s own trust department. While the fund never accumulated much institutional money (“I wouldn’t even buy it for my mother-in-law,” one institutional investor said), it proved to be the beginning of a revolution.

In 1976 John Bogle created the first index fund that was available to individual investors. Bogle had been fired from his position at the Wellington Management Co. following irreparable personality clashes with the Boston managers. Determined that his new firm, Vanguard, should have its own stable of funds, and familiar with the growing evidence that actively managed funds didn’t tend to beat the market, he launched the First Index Investment Trust; it tracked the S&P 500 stock index.

The fund was to be started with an initial public offering of $150 million, underwritten by a group of big Wall Street firms. The IPO was an abject failure. Only $11 million was raised, and the fund remained small for years. The press named the fund “Bogle’s Folly.” Critics claimed that index funds guaranteed mediocrity—even that they were un-American. But Bogle remained determined and promoted the index fund with messianic zeal. Eventually, index funds became commercially successful and the most disruptive force in investment management.

Another important actor in the indexing revolution was Nate Most. His personality was the opposite of the hard-charging McQuown and the evangelistic Bogle. Most was a “geeky, avuncular former physicist,” as Mr. Wigglesworth puts it. His job at the American Stock Exchange, a struggling institution that was losing market share, was to find innovative products. He recommended an exchange-traded index fund. As it happens, I was a board member of the exchange, and, since a sponsor was required, I suggested that Most approach Bogle. He summarily rejected the idea: “Why would anyone want to buy the S&P 500 at 10 o’clock in the morning and sell it at 2 o’clock in the afternoon?” Eventually he was able to sell the idea to State Street Global Advisors, and the ETF revolution was under way. Within a decade, ETFs had changed not only the nature of indexing but also the entire field of investing, making passive management an acceptable and even an above-average method of investment management.

Mr. Wigglesworth worries that the concentration of power in a few investing behemoths could pose dangers. He notes as well that ESG investing—that is, investing based on the environmental and social effects of corporate governance—is the biggest current trend affecting the investment management industry. He questions whether ESG can provide acceptable returns, and whether it is even an effectual way to make environmental progress. Mr. Wigglesworth also considers the possibility that the indexing movement could have some harmful effects on the economy and distort markets, by having money invested in specific companies because of their inclusion in an index rather than because of their individual prospects.

He concludes that our “financial markets have always been a dynamic ecosystem.” Financial innovation has often led to gloomy prognostications, but over time it has added to the ecosystem’s “vibrancy.” What is undeniable is his final message: “Pretty much everyone saving for retirement, to send their kids to university, to buy a house, or just for a rainy day indirectly or directly reaps the benefits of the humble index fund.”

Originally published by The Wall Street Journal on Oct. 23, 2021

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