A raft of articles and books have been written about index funds.
However, there are few pieces that explain how the idea of tracking an investment market started and all that happened along the way.
Trillions, written by Robin Wigglesworth, a well known writer for the Financial Times, does all of this and more, bringing the quantitative evidence behind the index fund to life, with great stories about its history and the people that drove its success.
I reached out to Robin in the hope that he would spend a little time talking with me about his book. Robin was generous enough to speak with me for well over an hour on Zoom, late into the evening his time in Norway.
The summary of our talk below has been edited for clarity. It might be what the FT calls a Long Read, but I think you will find it interesting and insightful. I thoroughly enjoyed our talk and learned a great deal reading Robin’s book. If anyone would like a copy of Trillions, please let me know and I will send you one.
Preston: Trillions covers many different aspects of index investing, from the original ideas behind it, how it got started, and how indexing has grown to where it is today.
How did you decide to focus on this topic?
Robin: Index fund investing can come across as fairly boring. When you do a deeper dive, though, it has shaken up pretty much everything in the financial industry and I felt the ideas behind it were not well covered.
I’m a history buff, so I also wanted to tell a story about how the investment industry has evolved over the past hundred years through the prism of index funds.
This humble, unassuming, unlikely protagonist – the index fund – was widely derided at its birth. But, it has grown and hammered all of the people that used to make fun of it.
I try to tell a broader history about investing… how the idea of index fund invested started and then how it evolved.
I felt it was unfair to dump readers in 19th century France so, I started the book about a big bet – one between Warren Buffett and Protégé Partners.
The stakes were high and I thought it was a fun, cinematic way to explain what a hedge fund is as compared to an index fund.
Preston: Maybe something of a classic tortoise and hare race. An active manager that aggressively strives to outperform the market versus a manager that strives to track the performance of the overall market in a manner that may seem passive.
Robin: Yes. The bet from the head of Protégé Partners, Ted Seides, was that top hedge funds, selected by a well-resourced and seasoned manager selection team, would outperform an index fund designed to track the S&P500 over a 10-year period.
Buffett took the other side, that an S&P 500 index fund would outperform top hedge funds.
Warren won – Big.
Preston: It did indeed get a lot of press and maybe changed some opinions about indexing.
Robin: Yes – Again.
A problem with the bet is that, even if Seides had won, I don’t think it would have changed the fundamental data or the fundamental arguments in favor of indexing.
Preston: You mentioned 19th century France.
I’ve been in the investment business for the better part of 30 years, but I had never heard about the work of Louis Bachelier or that the evidence in support of indexing started in the late 1800s.
Tell us more about this – what did his research show?
Robin: I have a soft spot for Bachelier, as he died in obscurity, only much later to be recognized for his genius.
He was not necessarily interested in finance. Bachelier was a mathematician.
While working a part time job at the Paris Stock Exchange, though, he became interested in trying to decode the price fluctuations of stock prices. He became fascinated by it and ultimately he wrote his Ph.D. thesis on the movements of the market.
Bachelier quantified for the first time how stocks moved randomly – what Burton Malkiel famously coined a Random Walk. He is really a godfather of efficient markets.
Preston: Next, you mention Jimmy Savage. If it hadn’t been for him, and a somewhat random discovery of Bachelier’s Ph.D. thesis, would indexing be where it is today?
Robin: Jimmy Savage, whom Milton Friedman described as “one of the few people I have met whom I would unhesitatingly call a genius,” literally discovered Bachelier’s Ph.D. thesis by chance.
Savage happened to be best buddies with the Nobel Prize winner Paul Samuelson and sent him a post card literally asking if he had “ever heard of this guy,” saying that “Bachelier seems to have had something of a one-track mind. But what a track!”
Separately, Bachelier’s work then got to a young grad, Eugene Fama, who also went on to win the Nobel Prize, based on his further quantification of how low the probability of anyone being able to predict the price movements of stocks really is.
It is more complex than you can manage in a book narrative, but it was fascinating seeing how the idea spread.
Preston: As you wrote, Bachelier’s work “helped explain one of the most puzzling aspects of the investment industry – why most professional money managers seemed to do such an abysmal job.”
Next, you mention Alfred Cowles, III, who also dove deep into financial data in an attempt to improve the way his family managed money.
Robin: Cowles was a relentless measurer. He’d count the average height of people that he met and loved counting or measuring everything in the stock market.
He was born into wealth, as an heir to the Chicago Tribune fortune, but he was struck with tuberculosis in the 1920s.
Cowles was sent to Colorado to recover and, while there, with more time on his hands, he took over the management of the family fortune.
When the Great Depression happened, he was shocked to discover that all the newsletters and research reports he subscribed to were useless.
To try to get to the bottom of why, as far as I can tell, he put together the first comprehensive study of how well professionals predicted the stock market.
Cowles went through everything. He analyzed the track records of leading insurance companies (some of the largest professional investors of that time), dozens of investor publications (the research reports of today), and Dow Theory, which was first espoused by Wall Street Journal founder, Charles Dow.
His findings were published in a 1932 paper titled, Can Stock Market Forecasters Forecast?
Cowles summed up the results of this study in a three-word abstract:
“It is doubtful.”
He basically ended up finding that the industry was turning out a lot of chaff and not a lot of wheat.
Preston: And, as you also mentioned, IBM reached similar conclusions in the 1940s, when they used early computing systems to analyze approximately 7,000 investment forecasts.
Robin: The story of indexing tracks the dawn of the computer age quite well, because people, with computers, could do type of analysis required to verify how well investors had performed.
The real Genesis moment in the eyes of many was the work done by the Center for Research in Security Prices (CRSP) in the early 1960s that was commissioned by Merrill Lynch.
Merrill wanted to sell stocks to ordinary Americans, but the SEC prevented them from running ads promoting stocks, saying that they needed to prove that stocks were a good long-term investment.
To make their case to the SEC, Merrill hired Jim Lorie, a professor at Chicago, and his colleague Larry Fisher, to crunch the data.
To help make the case, though, they first had to find out what the total returns of stocks had actually been – something that had never been accurately quantified.
After spending four years creating a database that covered decades worth of old journals, Lorie and Fisher found that the long term return of the U.S. stock market had been about 9% per year.
Merrill Lynch was pleased and, based on this return, the SEC allowed them to print their ad.
It was very successful and powered Merrill’s Thundering Herd of stock sales professionals across America.
Problematically for the investment industry, however, was the 9% annualized number – not far off what is still the long-term average yearly return for stocks in the U.S.1.
Lorie and Fisher found that return of the market as a whole was quite a lot higher than the average returns of professional investors.
Preston: Even though it was commissioned by the industry, they got back something that they might not have wanted – that their promoted stock picking might not be adding much value?
Robin: I’m sure they edited that part of it.
Preston: One of my biggest take-aways from your book is this:
Since 1900, we have been crunching the numbers and data.
Every time we have analyzed numbers, each time with better and better databases and systems, we get the same conclusions – most professional investors don’t beat the market.
Robin: I think the conclusions started coming even before we had the data.
Fred Schwed famously wrote Where Are The Customers’ Yachts? in 1940, right?
There was an understanding after the South Sea bubble, the Mississippi bubble, the Great Depression, when investment trusts were stripped of all of their infallibility…
That… professional investors weren’t actually that good.
People are really good at ignoring inconvenient truths, though, and before the internet, it was a lot easier.
Data started being compiled in the 1930s by people like Cowles. In the 1960s, computers then allowed things to all come together.
I wouldn’t say in an irrefutable way back then, but pretty comprehensively.
Preston: In spite of all the building evidence, though, you write about how, without the dogged support of the Chairman of Wells Fargo, index funds might have never really gotten off the ground.
Robin: In a paradox, we think of the 1970s as an era of wasteful CEOs spending.
But without a pet project, run by John McQuown, that was funded by two separate heads of Wells Fargo, index funds might not be what they are today.
With somewhat of an unlimited budget, and losses that lasted for about 20 years, McQuown was able to build what was probably the biggest collection of big investment brains that has ever been assembled.
I call it the Manhattan Project of Finance, that at various points included Bill Sharpe, James Lorie, Lawrence Fisher, Michael Jensen, Harry Markowitz, Merton Miller, Jack Treynor, Fischer Black, and Myron Scholes.
They worked on many things like FICO scores and what eventually became MasterCard.
I believe that the index fund was the greatest invention of them all.
In spite of significant initial opposition from the stock pickers inside the Wells Fargo Trust Department, it eventually morphed into Wells Fargo Investment Advisors, which then became Barclays Global investors, and finally Blackrock, the world’s biggest investment company.
This pet project revolutionized the investment world and I’d argue was the start of quantitative investing.
Preston: You just mentioned something I’ve thought a lot about over my career.
My first job in money management was at State Street Asset Management, what is now called SSGA, the home of many large index ETFs such as SPY.
As you mention in your book about Wells Fargo, we had two different floors.
One was the Trust Department, which managed money in a fashion that is now called active management.
Index mutual funds and ETFs didn’t really exist at scale at the time, but on my floor we managed sizable index tracking strategies for large pension funds, employing many math majors, PhDs, and CFAs, who actively worked to develop quantitative models to manage money.
Fast forward to now, even though I could argue that the index floor was much more active than the Trust Company floor, we would call the Trust Company floor active and the index floor passive.
How did this come to be?
Robin: The line between active and passive is certainly arbitrary and gets blurred all the time.
The way I see it is sort of an axis of systematic versus discretionary.
Index fund investors were the first systematic investors – the genesis of quant investing.
Index investing is just one facet of quant investing – the biggest one, but just one.
A lot of the people that invented index funds were not efficient market zealots. They were just trying to develop strategies that were able to achieve the performance of the market as a whole.
Based on what the quantitative studies were showing, if they could do this, they believed they would be able to produce better performance.
Preston: When selecting an investment manager, I argue that you want to find a manager that is extraordinarily process driven, has high rigor and, following the data, constructs portfolios in a systematic way.
Along these lines, is there really much difference between good index management and good active management?
Robin: Today there’s a widespread recognition that the best active managers are not the iconoclastic geniuses.
They might be geniuses and they might be iconoclastic, but you want someone that has a repeatable process.
The idea of being able to find a great person, entrusting it to this great person until they lose their touch, and then searching for another one, has come under question.
With measurement, we’ve come to realize that many investment managers have just delivered the returns of the market, or a segment of it, minus their costs.
Over the past fifty years, I think there has been a greater realization that a lot of what the better active managers do can be quantitatively systematized and packaged up more cheaply.
You could argue that Ben Graham was the original quant, because he was a very rigorous person. He liked numbers. He liked measuring things and believed in a rigorous scientific approach to investing, which was actually anathema at the time.
Preston: Graham is also often called the father of value investing.
Tying this back to the story of indexing, do you think it would exist at the scale it does today if it were not for another maybe random event…
The long stretch of value underperformance in the late 1960s, which led to the rise of the so-called aggressive growth Whiz Kids in Boston, such as Nick Thorndike, who took over an old line value firm in Philadelphia, Wellington Management.
Robin: That’s a good question.
Without Thorndike, his partners, and their growth fund, there probably wouldn’t have been a Vanguard.
Turning the clock back, Bogle was hotshot young executive at Wellington and was given the reins in the 1960 to run the firm. Unfortunately for him, this was maybe the first growth bubble and Wellington’s conservative value management style wasn’t considered to be cool anymore.
In an effort to reinvigorate the firm, Jack decided to merge Wellington with the go-go era Boston manager you mentioned, Thorndike, Doran, Paine, Lewis & Doran.
Everything worked fine to start but, as we know, nothing raises tensions as much as a nasty bear market, and after the large market drop in the 1970s, Jack got sacked.
Connecting on a Hail Mary pass to try to stay in the investment business, Jack was able set up a new firm originally owned by the Wellington Funds that would do administrative work for the funds.
Though a loophole that Jack created, a more computer driven form of investing that he also proposed was considered to be administrative, so was allowed to be done as it was not deemed to be competitive to Wellington.
It eventually all came together and, with a grandiose name that Jack coined, Vanguard’s index fund management started.
I think indexing would definitely be here but, without the zeal to succeed that Bogle brought to it, I don’t think it would be where it is today.
Preston: Near the middle of your book, you talk about how a more tradable form of index fund management, an Exchange Traded Fund, was started.
What was the original case purpose of ETFs?
Robin: The spark was probably the stock market crash in 1987.
The SEC and the Treasury came out with a report of the big market drop that is now called Black Monday. It directed some blame on the programmatic trading of stock market futures.
They suggested that, if there was some sort of investment product that traded the entire stock market during the day, it could add a buffer between the futures linked to the entire S&P 500 and individual stocks.
Many ideas on this got killed, but eventually it got picked up by a new product person at the American Stock Exchange, Nate Most.
Most, through a combination of raw brains and creativity, came up with the idea to create shares of an index fund that could be traded like a stock throughout the day, which might help tackle the issue the SEC and Treasury were concerned about.
From this, the ETF was born.
Preston: In my first job at State Street, before I transferred to the Asset Management Division, I was tasked with writing overnight S&P500 futures contracts for large active mutual funds, such as the Fidelity Magellan fund that was run at the time by Peter Lynch.
These active managers did not like to hold cash after they had sold a position or taken in new funds, so they would buy large S&P500 futures contracts to remain fully invested and not potentially fall behind the market if it ran.
Reading your book brought this back to me and made me think more about how ETFs are often used. Versus using future contracts to stay fully invested, or express a market view, are active managers actually some of the largest investors in index ETFs?
Robin: Active managers are large users of index ETFs.
The Amex Stock Exchange started ETFs to create trading revenue, hoping that they would be an attractive trading vehicle for hedge funds and other active managers.
It took a while, but hedge funds were some of the early adopters of ETFs, as were other asset managers.
Preston: Later in your book, you mention a few concerns that some have voiced about ETFs and index fund management.
Do you think that some of the commentary about ETFs being worse than this or that is related to some ETFs being constructed in ways that were not originally contemplated?
Robin: Yes, I think so.
Jack Bogle didn’t like ETFs, by the way, and famously said that they were like Purdy shotguns. They were good at shooting big game but also had become a tool to commit suicide.
Jack had a wonderful way with words and could be very evocative.
I think some of Jack’s words, and those of others along these lines, however, are a little over the top.
You can do dumb things with smart innovations, and I do worry that in some cases ETFs are becoming a tool to do a bit of regulatory arbitrage.
I think that is worth keeping an eye on, and if I was the lord regulator of all financial markets, I think I’d probably take a slightly more guarded approach to approving new more esoteric ETFs.
Despite many, many critics over the years and many years of confident prognostications of doom, ETFs have weathered a lot of major stress tests really, really well.
Preston: You speak in your book more specifically about concerns surrounding bond ETFs, but they held up well in what was a big crisis moment in March and April of 2020.
Robin: Yeah, I think that’s one thing that I got wrong.
If somebody told me what was going to happen in March 2020 ahead of time, I would have predicted absolute carnage for a lot of fixed income ETFs, especially some of the credit ETFs.
In practice, however, it showed the fundamental resiliency of the ETF structure and some of the advantages of it.
I’m still worried that at some point there’s going to be some sort of fault line that I am not aware of, but actually I am more positive on ETFs now than I was two years ago.
Preston: Along these lines, do you think we need to be careful when discussing index fund and ETF criticisms and make a distinction between broad market index funds and the subsets of sector and factor ETFs that are more tactical trading vehicles?
As you mentioned earlier, ironically, some of the managers and commentators that are critical of index fund investing actually hold large amounts of index ETFs in their portfolios. It is not uncommon, for example, to see a broad market S&P 500 ETF, such as SPY, as a top holding inside a hedge fund or other type of actively managed portfolio.
Robin: Very much so.
The ETF has transcended into just a new way to construct and assemble portfolios.
They are used like Lego pieces to build all sorts of portfolios and positions in size quickly. Bridgewater, Ray Dalio’s firm, for example, is a heavy user of ETFs and many other hedge funds are finding them as cheaper ways of putting on a trade.
I think some of the more niche, derivatives based, ETFs are worrisome.
That said, none of them have caused a major event.
Like you say, there is a danger that people start grouping all index funds and ETFs together. There is a huge variety in the index and ETF fund universe.
Preston: What are your thoughts on how investors should be view index investing concerns in general?
Robin: I’m personally skeptical of the concerns.
I can see pitfalls that investors need to keep in mind when using the sector funds or factor funds we just mentioned because, when using them you’re essentially market timing, and that is really hard even for the smartest money managers in the world.
As it relates to index funds impacting markets, however, or a concentration of power among index fund managers, this is not something for investors to worry about.
If you buy index funds from Vanguard or BlackRock, it will increase their concentration of power but, overall, this is still an industry that is fairly balkanized and fragmented.
The wrecking of market efficiency, or the sapping the American economy of its dynamism, is what some people in the industry seem to get the most excited about and about this, I am extremely unconvinced.
Indexing is still a small part of a very, very big pie. It is growing incredibly quickly and, even fans like me should not be denying that there are side effects on a micro level.
But, on a macro level, is this bad?
I think those arguments are frankly preposterous.
If market efficiency were eroding, somehow you’d expect to see the performance of active managers increase. In fact, we’ve seen the opposite happen in tandem with the growth of indexing. Less and less managers have been able to outperform.
Don’t imperil your financial future because of some ephemeral concern about market efficiency or the power index providers or BlackRock’s clout in boardrooms.
What I think is happening is what Mike Mauboussin calls the poker metaphor.
Preston: Agreed. Tell us more about how this may relate to poker.
Robin: The analogy is like when you get a group of friends over for poker – the worst players are typically the ones who pack up and go home first. When these players leave, the game doesn’t get easier, it gets harder.
I think that’s what happened with markets.
The competition from index funds, both on fees and performance, is winnowing out mediocre money managers. This raises the bar for the active managers who remain at a table, as they are competing against better and better players.
One of my heroes in the investment world is Charlie Ellis, the ex-head of Yale’s Investment Committee – David Swensen’s boss for many years.
Charlie talks about how hard it was for him to beat the market in the 1960s, a time when he was getting a PhD in economics, which gave him a huge edge.
As another example, in the past having a CFA was rare. Today, though, you can throw a rock on Wall Street and you’ll hit a CFA.
The quality of the people in markets is getting higher and higher and higher all the time. Some of the smartest people I’ve ever met in my life were in the finance industry, and to beat the market you have to beat this enhanced competition.
Many in the industry are incredibly diligent, hardworking, and are trying to do the best for their clients. Beating the markets is really hard, though, and you need a very compelling reason why you can plausibly tell investors you’re going to be able to do so in the long run.
Preston: Agreed – again.
Another concern that some raise is that as more money flows into index funds, not enough active managers are going to be buyers on the other side when the market drops.
On most every down day I have seen, though, the sellers are the so-called active investors – the buyers are index funds.
Robin: This is one of the most pernicious and annoying myths about index investing.
Some say that as more and more is indexed, a so-called smart buyer will not exist.
As it happens, though, during every single major downturn, as more and more has flown into index funds, the market has broadened, not been dented.
Money in index funds has proven to be stickier than money in active funds during downturns.
I find all this talk about what happens when everyone is in index funds a fantastical scenario.
It’s a popular straw man. The idea that markets will ever be 100% indexed is a ludicrous idea. It’s never going to happen.
Preston: The last figure that I saw from the Investment Company Institute, which is paid by investment management members to keep track of assets under management, is that less than 15% of U.S. stocks are held by index funds and ETFs.
This is up from less than 10% about five years ago but, even though flows into index strategies have been large, as the market goes up so too does the amount being managed in active funds.
It’s hard for index funds to gain market share as a whole unless the flows are truly epic and outpace the growth of the market by an extremely large amount for many, many years.
In addition, you have human nature to overcome.
I’m a big fan of index funds but some investors will never become comfortable with them, which is fine.
If holding an active manager makes an investor feel more comfortable, and allows them to stick to plan, then it might be the correct type of fund management for them.
This is one of the most powerful arguments for active management, I feel, and it’s one that the active industry doesn’t like because it feels like such a cop-out.
I think it’s the truest one.
We know that a lot of investors do worse than the overall market, not just because they choose an expensive active fund, but because they go in and out at the wrong time.
Some people like hand-holding. They like feeling that there is like a human at the controls and, even if the human underperforms, they can understand it – it makes them feel more comfortable.
That’s why a good financial advisor is important.
Preston: I appreciate the nod about financial advisors but I’m too conflicted to say much about that.
Back to where we started, it seems like we have been continuing to have some of the same debates over and over for almost 100 years.
Some of the methods used by Bachelier in the 1900s, and by Cowles in the 1930s, were not as precise as we would like.
By the time the time computers were able to crunch more numbers in the 1960s, though, they basically confirmed that Bachelier and Cowles were pretty spot on.
Robin: Yes, the data has been coming in thick and fast throughout the world, across every asset class, and it is even stronger than we expected because it’s been corroborated internationally.
Active managers do a particularly bad job on average in the U.S., as you’d expect. It’s a very efficient, very competitive market.
In less competitive markets, like emerging markets, active managers do better.
Over a 10 year period, there is not a single market I’ve ever seen where active managers on average beat the market.
Most interestingly, I think, it’s what is happening in the fixed income markets.
I think fixed income indices were never designed to have investment products on top of them and they are inefficient by nature.
But again, the data from the fixed income world shows that the average active manager cannot beat their index over a 10 year period.
Preston: This is what we’ve seen as well.
You have been very generous with your time.
Before we go, though, what is next for you? I hope another book is in order.
Robin: Some of the Genesis stuff for Trillions came from my interviews with Harry Markowitz, for a piece that I worked on for the Financial Times called the Volatility Virus.
The idea is that we’ve turned volatility into a proxy for risk and about the pitfalls of using it as shorthand for risk.
It makes sense mathematically, but we have embedded it into every crevice of the financial system, and I’ve long thought about maybe turning that into a book.
Preston: Joachim Klement and I discussed some of this in a piece that we wrote called Stats on Statistics.
The models that we often use to construct portfolios are based on sound theories but, to be stable, they need stable inputs. The problem is that markets, and the humans that move them, are anything but stable.
Robin: This is one of my favorite things to talk about.
I use lots of little mental models to help myself understand stuff, but they are only scaffolding – only models – shorthand that can be wrong.
You need to understand how they can be wrong and cannot get anchored on a model being accurate.
The financial world is way more complicated than anything like a Sharpe ratio or VAR an accurately explain.
Preston: I’d encourage you to write more about this.
As with your current book, Trillions, I think it would be valuable to many investors.
I have enjoyed this very much, but we should wrap it up, as it is quite late for you in Norway.
Robin: No problem. The kids are in bed.
Preston: Thank you again for the time and great thoughts.
Trillions is wonderful and I hope many investors will read it. It is a great walk through the history of the Random Walk, with many references to good data and interesting stories.
Robin: Thank you as well. I do love this stuff.
Beating The Field By Shooting Par – Dougal Williams, CFA
Challenge to Judgment – Paul Samuelson – Journal of Portfolio Management
Are Selectors Good At Selecting? – Elisabetta Basilico, PhD, CFA
The Simple Alternative – Charlie Henneman, CFA, Sloane Ortel, Preston McSwain
The S&P500 index, a broad measure of U.S. stock market returns, has been positive approximately 80% of the time on a calendar year basis, producing an average annualized return of 13% from 1950-2021.
Source: Standard & Poor’s and Crandall, Pierce & Company.