TRILLIONS: HOW A BAND OF WALL STREET RENEGADES INVENTED THE INDEX FUND AND CHANGED FINANCE FOREVER

by Robin Wigglesworth

Only 10 to 20 percent of active funds beat their benchmarks over any rolling ten-year period. In other words, investing is a rare walk in life where it generally pays to be lazy and choose a cheap passive fund.

However, in retrospect Seides does make one damning concession: If he was a young man today, he would not choose a career in investing. The profession has become increasingly competitive and difficult, and judging whether someone’s results are due to luck or skill is almost impossible. Moreover, it is a rare career path where experience does not necessarily make you more proficient, and being mediocre is of no value. “Your average doctor can still save lives. But your average investor detracts value from society,” Seides admits.

In other words, while a clever buyer might think he may be landing a bargain, a presumably similarly intelligent seller must be assuming he is getting a good price. Otherwise no deal would be struck. Therefore, at any given moment in time financial securities are priced at the level that investors as a whole and on average consider fair. This was a groundbreaking realization. And that was not all. Bachelier showed that financial securities appeared to follow what scientists call a “stochastic,” or random, movement. The most famous form of random movement was discovered by the Scottish botanist Robert Brown. While examining grains of pollen under a microscope in 1827, Brown saw tiny particles ejected by the pollen that moved around willy-nilly with no discernible pattern, a phenomenon that subsequently became known as Brownian motion.

In fact, Markowitz suggested that all investors should really care about was how the entire portfolio acted, rather than obsess about each individual security it contained. As long as a stock moved somewhat independently of the others, whatever its other virtues, the overall risk of the portfolio—or at least its volatility—would be reduced. Diversification, such as can be achieved through a broad, passive portfolio of the entire stock market, is the only “free lunch” available to investors, Markowitz argued.

Yet the best argument for the enduring value of the efficient-markets hypothesis comes from the eminent twentieth-century British statistician George Box, who is said to have quipped that “all models are wrong, but some are useful.” The efficient-markets hypothesis may not be entirely correct. After all, markets are shaped by humans, and humans are prone to all sorts of behavioral biases and irrationality. But the hypothesis is at the very least a decent approximation for how markets work—and helps explain just why they have in practice proven so hard to beat. Even Benjamin Graham, the doyen of many investors, later in his career became a de facto believer in the efficient-markets hypothesis. Fama later presented an apt, if lewd, metaphor to tweak the noses of investors who disagreed with his ideas, likening traditional money management to pornography: “Some people like it but they’re not really getting better than real sex. If you’re willing to pay for it, that’s fine. But don’t pay too much.”

The investment manager turned historian Peter Bernstein recounts that at the time one former colleague sputtered that he wouldn’t buy the S&P 500 even for his mother-in-law.30 The Leuthold Group, a Minneapolis-based financial research group, famously distributed a poster where Uncle Sam declared, “Help stamp out index funds. Index funds are un-American!” Copies continue to float around the offices of index fund managers as mementos of the hostility they initially faced. Of course, as the writer Upton Sinclair once observed, it is difficult to get someone to understand something when their salary depends on them not understanding it.

Direct indexing takes this to the natural next level. Rather than buy an index fund or ETF, an investor would buy all (or nearly all) the individual securities in a benchmark—allowing them total freedom to create their own flavor of investment portfolio, and, at least in the United States, more efficiently harvest any losses on individual securities. Imagine it being like having all the stocks of the S&P 500 or FTSE 100 as the default option, and then simply ticking off companies that don’t appeal. Hey presto, a bespoke index fund tailored perfectly to the customer’s sensibilities, which they can tweak when and in what ways they see fit. Direct indexing is not entirely new, but three recent developments have transformed its prospects. First, technological advances mean that it is now much easier to implement in practice. What was once a computer processing sinkhole is now more straightforward. Second, trading costs have plummeted in recent years, and are in some cases free, making the cost more competitive versus buying a cheap, simple index fund. Third, the emergence of “fractional” shares—the ability to buy part of a share of a stock if it is too expensive—has helped make direct indexing possible for a broader range of investors.

Bond indices are funny beasts. It makes perfect sense to set the relative weightings of companies in the big stock market indices according to their overall value. So Apple has a bigger weighting than Under Armour. But bond market benchmarks are weighted according to the value of debt issued. So, perversely, the more indebted a country or company, the more heft it should have in an index. Moreover, the greater the price a bond is trading at, the greater its weighting, even if that means it in practice offers a negative interest rate—a phenomenon that has become increasingly common given the vast monetary stimulus unleashed by central banks in recent years. In other words, the peculiarities of bond indices mean that passive bond funds are compelled to buy negative-yielding debt, in practice locking in a guaranteed loss if the debt is held until it matures.

As the IMF noted, the impact on the bonds of emerging economies is starting to become particularly noticeable. A 2018 paper by Tomas Williams, Nathan Converse, and Eduardo Levy-Yayati found that the “growing role of ETFs as a channel for international capital flows has amplified the transmission of global financial shocks to emerging economies.”18 In other words, while ETFs are helping funnel money to the developing world, their tradability makes countries more susceptible to sudden shifts in global investor sentiment, irrespective of domestic factors.

“Indices were designed as measures, but once you begin investing in them you actually distort them,” Green argues. “The moment they became participants and began to grow, they affected markets.”

Given that most index funds are capitalization-weighted, that means that most of the money they take in goes into the biggest stocks (or the largest debtors). Critically, and contrary to popular conception, an index fund does not automatically buy more of a security simply because it has gone up in price, given that it already holds that security. But if the fund takes in new money, then that will go into securities according to their shifting size, and that can in theory disproportionately benefit stocks that are already on the up. For instance, over the past four decades, on average 14 cents of every new dollar put into the Vanguard 500 fund or State Street’s SPDR would have gone into the five biggest companies. A decade ago it was closer to 10 cents. Today, it is over 20 cents—the highest on record.4 Although those bigger companies are, well, bigger, those extra cents can have a disproportional market impact, according to a 2020 study.5 In other words, size can beget size, a dynamic that could contribute to the tendency of financial markets toward bubbles, according to critics.

Moreover, Green argues that index funds are contributing to a secular increase in average stock market valuations seen since the financial crisis of 2008—but at the same time making markets more fragile in a downturn.

Yet in Green’s view, the biggest effect comes from how index-tracking strategies have now vacuumed up so much of the stock market. They have been the dominant “bid”—Wall Street parlance for the buyer—for stocks over the past decade. That leaves fewer shares for everyone else, even though their holdings aren’t excluded from index calculations. This is an issue because most big benchmarks like the S&P 500 are nowadays “float”-adjusted rather than purely value-weighted. In other words, how much space they have in an index is determined by the value of shares that are actually freely available to trade, rather than its total value. Imagine a $10 million public company whose founder owns half of its 1 million shares. That means 500,000 shares still trade freely on the stock market, and their $5 million value determines its weighting in indices—not $10 million. But index funds might now own another 20 percent, which they never sell unless they suffer investor withdrawals. That means other investors are in practice buying and selling just 300,000 shares worth $3 million, even though the value used to calculate the company’s index weighting is $5 million. Incremental buying—from active managers or index funds seeing further inflows—can then push the price up more aggressively, simply because there are fewer sellers around. In

“The stock market is supposed to be a capital allocation machine. But by investing passively you are just putting money into the past winners, rather than the future winners,” she argues. In other words, beyond the impact on markets or other investors, is the growth of index investing having a deleterious impact on economic dynamism?

Although the framing was deliberately provocative, it is undeniably true that index funds are free riders on the work done by active managers, which has an aggregate societal value—something even Jack Bogle admitted. If everyone merely invested passively, the outcome would be “chaos, catastrophe,” Bogle noted a few years before passing away. “There would be no trading. There would be no way to turn a stream of income into a pile of capital or a pile of capital into a stream of income,” Vanguard’s founder observed in 2017.20

There is a conundrum at the heart of the efficient-markets hypothesis, often called the Grossman-Stiglitz Paradox after a seminal 1980 paper written by hedge fund manager Sanford Grossman and the Nobel laureate economist Joseph Stiglitz.22 “On the Impossibility of Informationally Efficient Markets” was a frontal assault on Eugene Fama’s theory, pointing out that if market prices truly perfectly reflected all relevant information—such as corporate data, economic news, or industry trends—then no one would be incentivized to collect the information needed to trade. After all, doing so is a costly pursuit. But then markets would no longer be efficient. In other words, someone has to make markets efficient, and somehow they have to be compensated for the work involved.

Michael Mauboussin, one of Wall Street’s most pedigreed analysts and an adjunct professor at Columbia Business School, has an apt metaphor to show how the hope among many active managers that index funds will eventually become so big that markets become easier to beat is likely in vain: Imagine that investing is akin to a poker game between a bunch of friends of varying skill. In all likelihood, the dimmer players will be the first to be forced out of the game and head home to nurse their losses. But that doesn’t mean that the game then becomes easier for the remaining cardsharps. In fact, it becomes harder, as the players still in the game are the best ones.24 Although financial markets are a wildly more dynamic game, with infinitely more permutations and without the fixed rules of poker, the metaphor is a compelling explanation for why markets actually appear to be becoming harder to beat even as the tide of passive investing continues to rise. Mediocre fund managers are simply being gradually squeezed out of the industry. At the same time, the number of individual investors—the proverbial doctors and dentists getting stock tips on the golf course and taking a bet—has gradually declined, depriving Wall Street of the steady stream of “dumb money” that provided suckers for the “smart money” of professional fund managers to take advantage of. Perhaps there may be an element of the distortionary effects fingered by the likes of Green. But most fund managers willingly admit that the average skill and training of the industry keeps getting higher, requiring constant reinvention, retraining, and brain-achingly hard work. The old days of “have a hunch, buy a bunch, go to lunch” are long gone. Once upon a time, simply having an MBA or a CFA might be considered an edge in the investment industry. Add in the effort to actually read quarterly financial reports from companies and you had at least a good shot at excelling. Nowadays, MBAs and CFAs are rife in the finance industry, and algorithms can read thousands of quarterly financial reports in the time it takes a human to switch on their computer.