In this session, I interview Robin Wigglesworth, FT’s global finance correspondent, based in Oslo, Norway. He focuses on the biggest trends reshaping markets, investing, and finance with a particular emphasis on technological disruption and quantitative investing. Robin is the author of incredible research into the story of the Index Fund, but also the story of how passive investing evolved. That is the topic of our discussion.
- How did you get to write a book about this topic?
- Can we go a little bit through the early days of index passive investing? How was the index fund born?
- How did this all conflict between active investing and passive investing come along? What were some of the key years?
- Who were some of the “founding fathers” of passive investing?
- What were some of the initial payers that managed to technically put together an index fund?
- How did a minor bank at the time (Wells Fargo) get into index funds?
- What was the main driver behind such a huge effort toward building this index fund?
- Who were some of the pioneers of the index fund?
- What were some of the initial ideas of Bogle, among the fathers of the index fund?
- What motivated Bogle to create Vanguard?
- How did Bogle use press coverage to shape his personal story and build his own myth?
- When can we say the index fund, in the modern sense, was born?
- Would the exchange-traded fund be that kind of monster that was envisioned as a purist or more … What do you think? Or there was already an index fund that represented that vision?
- What happened at Vanguard, when Bogle was to leave and then he came back?
- Who was a pioneer in the ETF space, which represented an evolution of the Index Fund?
- How did the ETF, for instance, take off? Was there something that helped them to take off in a way that was not expected by players in the industry?
- What’s next? What is a trend that you’re looking at which is as interesting as ETF? Or it’s probably still ETF, the big deal so far. Is there an evolution that you’re seeing right now?
- What’s next for you? Are you going to write another book? If so, what topic, or what you’re looking for?
How did you get to write a book about this topic?
I’m a journalist at the Financial Times. That’s my day job. Between 2015 and 2019, I was the US markets editor at the FT New York. The way the FT is set up, we can’t cover everything that happens around the world all the time, so we have to be a bit more like special forces. We have to be very focused on where we spend our efforts.
For me, the rise of passive investing was just such an incredible story that was under-told because it doesn’t have many of the other personalities that we know in banking. There is no Jamie Dimon of index funds, there’s no Ken Griffin of index funds because we’re essentially just algorithms that buy all the stocks or bonds in an index.
But it was huge. Now it’s $20 trillion. $20 trillion in index funds. That’s more than the combined hedge fund, private equity, and venture capital industries. Twice that, actually. If you take all the venture capital, hedge fund, and private equity industries, double the size of them, and they still wouldn’t be as big as index funds. The more I realized the enormity of this, and saw the many ways it was changing the wiring of financial markets, I felt it deserved a book to explain how this revolution happened and what it means.
Yeah. For a little bit of context, 20 trillion is actually larger than the US GDP. Probably the US GDP is 17, 18 trillion, or something. Something like that. It’s a huge industry.
You also found a way to tell the story, and, as you said, passive investing is about algorithms more than people. You instead manage to tell the story in your book, Trillions, in a way that makes it very, very compelling.
Can we go a little bit through the early days of index passive investing? How was the index fund born?
Yeah. No, I wanted to write it almost as if it was a movie script. I think people are interesting, anyway. I think narratives help us understand complex developments that otherwise would be hard to grasp, and doing it through the prism of people just makes it more digestible.
I start the story with Louis Bachelier, a 19th-century French mathematician, who died in obscurity, that is arguably today the father of financial economics. The entire field of financial economics starts with Louis Bachelier. A lot of his work that wasn’t recognized until long after he passed away was a foundation stone for what became known in the ’50s and ’60s as the random walk theory of how stocks moved around, and eventually efficient markets.
Of course, there are many people that don’t think markets are efficient, and I have some sympathy with that, but that was absolutely pivotal in why the first index funds were invented. Index funds work whether you think markets are efficient or not, but some first-generation index funds were based on that idea. That’s why I think Louis Bachelier is rightly considered the godfather of passive investing.
How did this all conflict between active investing and passive investing come along? What were some of the key years?
Yeah. The whole idea of active versus passive just didn’t exist for centuries of investing. Ironically, the very first pooled investment vehicle, the first kind of mutual fund, was kind of an index fund. It was a passive fund. It was a bond in the Netherlands that basically bought lots of physical paper bonds and locked them in the chest for 20 years. That was a passive investment vehicle before anybody ever talked about the idea.
For a long time, the way you invested was either, if you were very wealthy, you invested on your own, maybe through a stockbroker, or you gave your money to a professional, so an investment trust or later a mutual fund manager. Every time markets had a big setback, such as the South Sea Bubble, the Panic of 1907, and the Great Depression, people realized that even the professionals quite often did a very bad job. Even the ones that had done well in the boom years inevitably did even worse in the bad years.
Nobody was really able to prove it quantitatively properly until the 1960s, because of the era of the computer. For the first time, computers started cropping up on Wall Street, and people started to use them to actually crunch the data. First, manually collect all the data on stock prices from newspapers, and see how well average mutual fund managers, or pension fund trustees, and so on, did against the broader market. Lo and behold, they did abysmally.
At the time, the answer was always, “You can’t buy the market average, so good luck. You can say that we don’t do that well, but there is no alternative.” That’s why the index fund was born in 1971 because people wanted to give investors an alternative.
Yeah. There was also a technical issue … Of course, as you pointed out, there are two key points to highlight.
First of all, before you could have computers to track the data and actually have a study that would show, looking back on decades, whether stocks were performing better compared to other markets like bonds. It’s also worth remembering that, now we give it for granted, but there’s been a time when even stocks were not the main investing or main asset class for investors.
Of course, as you said, one was the availability of data and the ability to actually analyze that data and actually put it together in the first place. Therefore, as you mentioned, computers definitely helped along the way.
The second point, I think it’s very important to stress out, which is, it was very hard to have an effective passive investing strategy because I guess it was very hard also to have diversified portfolios, so much so that it could be effective against active investing. Meaning, in order for you to also be effective in passive investing, you had to have a very large portfolio location.
That was something extremely, extremely hard, and challenging to do from a technical standpoint, so definitely we needed some technologies that we were missing back then.
Definitely, computers helped, not just in terms of analyzing the data, but also in a set location. Are those good points to emphasize, or do you think there is more to say about how passive investing became more mainstream compared to active investing?
Who were some of the “founding fathers” of passive investing?
No, I think that’s spot on. One of the other heroes in the book is a guy called Harry Markowitz. He was an economist who actually didn’t have that much interest in finance investing, but happened to write his Ph.D. thesis on optimal portfolio allocation.
He realized, obviously, you want to measure, you need to … If you take more risk, then you should expect more return, and so forth. He used volatility as a proxy for risk, which showed that, by more diversification, by putting in a lot of different securities, as long as they move independently of each other, the overall riskiness of the portfolio fell.
That is the foundation stone for how big institutions still manage money. That’s why they have a bit of money in stocks, a bit of money in emerging markets, a bit of money in hedge funds or private equity, in venture capital. Hopefully, the idea is that, over time, some of these things might be very risky, but as long as one does well whilst the others do badly, or vice versa, then, over time, you should have a better, more balanced portfolio.
It was his protege, Bill Sharpe, and, ironically, both of them won Nobel Prizes in economics for this work, that showed the optimal trade-off for the stock market, or for the market as a whole doing risk and reward, was the entire market. That was the optimal amount of diversification. That’s obviously a foundation stone for passive investing.
Bill Sharpe never talked about an index fund, he talked about the market portfolio. The Greek letter he assigned to basically denote the market’s returns was Beta.
That today is the lingua franca in the investment industry for the overall market return. Passive investing is what people sometimes call it to be mean. Index funds are quite often what people inside the industry like to call it, or if they’re being fancy, it’s the beta return.
Yeah. Of course, Sharpe really enhanced the work of Markowitz. As you mentioned, he built those two key measures. On one side was the beta, and on the other side was the capital asset pricing model, where the beta is one of the key components which is plugged into the model to actually compute, pretty much, do financial modeling of the value of stocks in the first place.
I think there is an interesting aspect that you also mention in the book, that of course, those are very important inventions, especially from a philosophical standpoint, to make the shift between active and passive investing. But, also, when we finally see the first index funds to build up over time, the mechanism behind those funds actually was also way more simple. They were actually simpler than just using complex financial metrics behind them, right?
It was more like a technical challenge, as we said, to have a fund that would be large enough, and also have the right allocation to make it valuable in the marketplace in the first place.
What were some of the initial payers that managed to technically put together an index fund?
There were essentially three people that got to the promised land at the same time. They all have different claims for being the very first index fund. One was Dean LeBaron at Batterymarch in Boston. He’s this really crazy, zany, outgoing guy who … He was not an efficient market zealot, but he realized that a lot of clients were going into him and saying, “We essentially want a low turnover, a very diversified bunch of US blue-chip stocks.”
He realized what they were describing was the S&P 500 index. He said, “I’ll just engineer that. It’s just an engineering challenge. We’ll sell that at a low cost as separately managed accounts.” He did this, and he started doing this right at the start of 1973, but he didn’t actually get a single client until the last day of 1973 when the money arrived in early 1974.
There was another guy called Rex Sinquefield at the American National Bank of Chicago. He was an efficient market zealot. He believed deeply and still believes deeply in it. He was a protege of Gene Fama, the father of efficient markets in Chicago. He created an index fund because he believed that markets couldn’t be beaten.
He did it by converting an existing, basically, S&P 500 active fund managed by the American National Bank of Chicago into an index fund. He basically just told investors that the object hadn’t changed, they were still trying to deliver good returns to clients, but how they would do so had changed. Nobody really objected. That was in mid-1973.
Two years before that, and this is why I think this is the first index fund, John “Mac” McQuown at Wells Fargo, and some of his colleagues, launched what was the first passive investment vehicle. It was not a fund or a classic fund, it was a separately managed account that managed $6 million on behalf of the Samsonite pension plan. Samsonite, the luggage maker, played a small but pivotal role here. That tracked all the stocks on the New York Stock Exchange, and it had tried to aim for an equal dollar amount in each of them.
That fund … First of all, it wasn’t actually a fund, and, logistically, the rebalancing that they had to do all the time to try and keep the dollar exposure constant across the stocks was monumentally big. It just turned into being a massive nightmare. Eventually, it got converted into an S&P 500 index fund a few years later.
That’s why, depending on how you define it, different people can claim to have got there. But, in my eyes, the real, original index fund, a passive investment vehicle, was the Samsonite account managed by Wells Fargo that went live in July 1971.
Yeah. Definitely a very interesting story. A couple of points that I want to emphasize from what you were saying, number one, of course, building a successful index fund turned out to be a very hard engineering problem.
Right? Really, it turned out to be a mess. It wasn’t just a theoretical problem, was just, “How do we actually build this thing from an engineering standpoint?”
Then, on the other side, also, it wasn’t yet the time where … Because we give for granted today main indexes like the S&P, the NASDAQ, or all the other main indexes that we have. For instance, today, it’s also simpler, probably, technically to just plug some index funds to the main indexes.
But, at the time, I guess we didn’t even have them. For a little bit of context, otherwise, it’s very hard to understand how difficult it was technically to build such an index fund. Also, the last point, how was that conceived to Wells Fargo, which I guess at the time was not a major bank?
How did a minor bank at the time (Wells Fargo) get into index funds?
To take that last point, I think it’s fascinating that … It’s a truism, but big companies don’t like disrupting themselves. We see this again, and again, and again. The mental model I’ve always used for index funds is that they’re almost like new technology, like electric cars, Netflix in the era, or Blockbuster. Other companies might have danced around the idea or realized this might be a good idea, but it’s just very hard to do that if you’re a big incumbent.
Wells Fargo of the ’60s and ’70s, when Mac was working there, was not the Wells Fargo of today. It was a tiny pissant regional bank of no significance, really. There were all sorts of rules and regulations that prevented banks from becoming some of the national behemoths that we know today.
I think the fact that because Wells Fargo was so small because the American National Bank of Chicago was so small because Batterymarch was a startup asset management firm, that allowed them. That was one of the things that made them willing to do this. It’s no coincidence that a Fidelity, or a State Street at the time, a Bankers Trust, didn’t do anything like this.
The actual logistical work needed to set up index funds was huge. Today, this is stuff that is quite literally sold for free or close to free by Fidelity, Charles Schwab, or Vanguard. It’s basically almost the simplest, dumbest form of investment algorithm you can imagine, just basically, “Buy all the stocks according to the weighting in the S&P 500 index.”
But, at the time, there was no electronic trading. Portfolio analysis, it would take hours to run through portfolio analysis on these big, hulking IBM mainframes. The data wasn’t collected. It wasn’t electronic. You had to literally collect the data from old copies of Barron’s in their archives.
I have to admit, I knew intuitively how much hard work it must have been, but actually talking to the people involved today for my book, I was taken aback. I thought, “Bloody hell, I wouldn’t have been bothered to do that if I was there.” It just sounded incredibly hard work.
The first project to really collect a comprehensive database of US security prices was funded by Merrill Lynch. It was done by the University of Chicago, something called the Center for Research in Security Pricing, or CRSP. It used, I think it was, half a million dollars, which was a huge amount of money at that time, and took four years to collect all this stuff and clean up the data. It was on a magnetic spool that stretched for something like four miles.
That database is the genesis moment for the entire quant revolution that was to come, because that was the database that became the raw fuel for not just index funds, though index funds were a huge part of that, but pretty much everything that came since. CRSP today is still a big data provider for investment groups like Vanguard. Yeah. I shudder to think about how much work there was involved in doing this in the early days before portfolio trading or anything like that.
What was the main driver behind such a huge effort toward building this index fund?
This is why I think those three pioneers that I focus on, the motivations varied quite a lot, and they still ended up in the same place, basically. For Dean LeBaron at Batterymarch, he just thought this was something that clients wanted. He didn’t think they should charge a lot of money for it, because there was no real management involved. He thought, “The S&P 500, it’s a decent shorthand. That’s what a lot of people want.” Some people want the very growth-oriented investing that he was known for.
A young Jeremy Grantham was working at Batterymarch as well. He was Dean LeBaron’s partner. They were active managers. They just felt that a lot of people don’t really want active management, they just want something like a big, boring portfolio of diversified, big US stocks. That’s the S&P 500. “We’ll just basically replicate that.” For them, it was just pure client demand and an engineering challenge, and not much more than that.
Though, I think, Dean LeBaron, he’s quite a character. I think he quite liked the idea of tweaking the noses of other people in the industry. He actually enjoyed, got a personal rise out of that.
Rex Sinquefield, he’s the classic efficient markets guy. He calls himself the Ayatollah of efficient markets. He doesn’t think that markets can be beaten in the long run. The reason why he set up an S&P 500 index fund was purely because that it was, at those times, with those practical constraints, you couldn’t trade small-caps and micro-caps at the time. The S&P 500 was the cleanest representation, the best representation of the entire stock market as a whole. That he chose the S&P 500 as his aim, that was more than this is, again, a good shorthand. He came to it as an efficient markets guy.
I think with Wells Fargo, and Mac and some of those people there, some of them were efficient markets believers. Mac certainly hero-worshiped Gene Fama, and they’ve worked together. Still, work together in their eighties today. But I think they just wanted to research a better way of investing, and they could see the data that the average active manager did a bad job.
They just basically ran the data, and there were people like Myron Scholes and Fischer Black, who were absolute rockstar economists that both … Scholes won the Nobel Prize, and Fischer Black passed away before he could do so, for the Fischer Black-Scholes model.
They essentially researched, what is the best systematic way of investing? What they ended up with was an index fund, but they were fundamentally not efficient market zealots. They were looking at ways, “What is the best, cheapest, efficient way of investing?” An index fund just happened to also be the answer they came across.
That’s why I think that quite often people think, because of its genesis, that index funds and passive investing only work if you believe markets are efficient. No, it doesn’t. You can think markets are horrifically inefficient, or that they do dumb things all the time like humans do all the time. But, in the long run, the data is pretty irrefutable. The vast majority of investors do far better in passive vehicles in every asset class, over any time period, in any market. That’s where all these three people ended up at, though in different ways.
As we see there, those are the points that make passive investing more interesting in some areas compared to active investing. Things that, as we know, when you start having a high frequency of investing, of course, most of the profits are eaten up by the cost of trading, which also, as you point out in the book at the time, could be pretty high.
Huge. At the time, that was one of the big things. Today it’s the management fees. It’s the cost of professional asset managers, portfolio managers, traders, back-office lawyers, and compliance staff. The trading costs are pretty low, almost zero. But, 50 years ago, the trading costs were the real headwind. The more you traded, the worse the returns were, essentially. That’s what index funds would also aim to try and tackle.
Yeah. Of course. As we said, it is not just about going against the efficient market hypothesis, it’s also trying to create an investment strategy where you don’t have the cost structure they usually have in active investing. Especially where, in active investing, sometimes your whole compounding is eaten up by not only the cost of trading but also by management fees.
There is an old philosophy of Warren Buffet when he’s asked, “What’s the best way for average people to invest?” He would always ask for, as also you highlight in the book, that definitely index funds are the best way for average people. It’s also because, compounding, when there are management fees that are high management fees, those eat up the whole effect of compounding. Therefore they remove the most interesting part of investing, which makes investing powerful in the first place.
There is also another key point that you highlight in the book. It’s pretty interesting to me because we also go over the story Bell Labs in this podcast series. There’s been a certain time, probably throughout the ’70s, where they formed also economic incentives toward index funds. As you mention in the book, there was a time when AT&T, which was still a large monopoly in the communication industry, had used the Baby Bells, which were regional companies, part of the Bell System, to actually invest in index funds, right?
There was also … Here, there were some economic incentives that also started to work in favor of passive investing.
Who were some of the pioneers of the index fund?
Yeah. The Baby Bells were hugely important. They weren’t efficient market zealots, they just were the biggest owners of stocks in the entire United States. They could see the results were bad, and, index funds, the results were better.
Yeah, after that … The Baby Bells were huge, important backers of Batterymarch, American National Bank of Chicago, and Wells Fargo initially. I think, for the first few years, this was only an institutional phenomenon. Ordinary people didn’t even know about this stuff.
This started to trickle through because of people like Charlie Ellis, who was a fairly well-known investor who wrote a paper called The Loser’s Game that pointed out some of this data that was coming out, and how bad it was. And Burton Malkiel, another economist who popularized and brought to the mainstream the idea of … The Random Walk Down Wall Street is his classic book that’s still … It’s in the 20th edition now. I think it’s still an absolute, stone-cold classic.
But the person that really helped to fire up index funds, though not immediately, crucially, which I thought was fascinating to discover, was obviously Jack Bogle. He did not invent index funds, despite him sometimes quite happily letting people give him credit for it. He only came into index funds almost by accident, because he was fired by his former partners at a company called Wellington where he led a big active management outfit.
In the divorce agreement, he was basically set up a clerical outfit that would do all the administrative work for Wellington, and he gave it the grandiose name Vanguard. He wanted to do something, but there was a lot that they couldn’t do. So they did index funds with the argument that this wasn’t investment management because an index fund was unmanaged. That was the genesis of Vanguard.
As much as he sometimes later in life would pretend that this was all part of a massive plan, it was happenstance that made Jack Bogle the Jack Bogle we now know today and Vanguard this Titanic asset management group, with, I think, well over $8 trillion worth of assets under management today.
Yeah. Also, initially, he thought of the index fund as a dumb idea, right?
What were some of the initial ideas of Bogle, among the fathers of the index fund?
Yeah. Exactly. No, I think … This is something I notice a lot as a journalist, as well. When I talk to people that are immensely successful, obviously they have a lot of drive, but quite often there’s some sort of personal or professional tragedy or major setback early in their lives that have really taken that drive and has lifted it 20 notches above what most people have. I think, for Jack Bogle, there was his family background, but it was the humiliation of being sacked from Wellington.
He was a man that came initially … Was born into wealth. His family was a very wealthy Pennsylvania family, but they lost their entire fortune in the Great Depression and the Great Crash of ’29. His father became an alcoholic and essentially left the family.
It was that sense of having fallen from wealth to … They were still comfortable, but they had to work. All the Bogle boys … He had two other brothers, including a twin. They all had to work incredibly hard. They could only afford to send one of them to university, and that was Jack Bogle. Even then, he had to work his way through university at Princeton.
Imagine if you’re only one of three brothers, the pressure that puts on you, that, “We can only send one of you. Jack Bogle has the best grades, so he’s going to university.” You’re working to repay the trust of your entire family.
He did work incredibly hard, and he was brilliant. He was noticed very early on by the founder of Wellington, which was one of the biggest mutual fund companies in America at the time. He was the wonder boy of the industry. He became one of the youngest junior vice presidents, one of the youngest executive vice presidents, then, ultimately, the youngest CEOs of the investment industry at the time. Still, almost to this day, he would’ve been considered a wonder boy.
He was a guy that had this drive. Everything he touched turned to gold. Yes, he then pseudonymously wrote an article, a paper, rubbishing the idea of index funds in 1960 when somebody proposed it. The world was his oyster.
But then he basically made a fateful decision to merge Wellington with a bunch of growth managers in Boston and gave up too much stock to do so. Eventually, when the late ’60s, early ’70s bear market happened, the clashing personalities and terrible business, because Wellington did badly in that bear market, meant that basically they ganged up and sacked him.
I think that just fired him up to just unimaginable levels, and gave him the drive that made him this force of nature. And helped turn Vanguard, which could have just been a cushy retirement job, too… He decided to turn it into the instrument of his revenge against anybody who doubted him, and to prove them wrong, that he was brilliant, that he was incredible. He succeeded beyond even his imagination, I think.
Yeah. A few key points based on what you said. Bogle, it’s very interesting because, of course, as you said, he grew up in a very tough situation, and actually his character very came about also as a contrast with his father, where he saw his father as a weak person. He was way stronger. As we see, he also had many health issues over the years.
Then, on the other side, the turning point would be when finally there will be this contrast with his partners, where Vanguard becomes a way for him to actually say, “I told you so. I showed you how I could do something extremely valuable in the world without you,” or even, “do something better than you’re doing.”
Also, another interesting point that you mention in the book is that … At least I’m not sure if you find this to be real, but it seems like he didn’t know who Markowitz was. He started Vanguard from a position of, really, “I’m going to do it because I want to give,” let’s say, “a kick in the butt to my former partners,” was the story of the early years.
What motivated Bogle to create Vanguard?
No, I think I remember talking to one of his closes, close friends, and former assistants about this, who, this was in the later years of Jack Bogle’s life, said, “Look, why are you trying to erase other people from history? Your role is so huge and what you’ve done is so monumental, you don’t need to do that.”
I don’t think Jack Bogle did it because he was mean-hearted at all, but we all have certain stories that we tell about ourselves and how we became the person we became. The reality is always a lot more complicated than even we admit to ourselves. I think we all do this, and Jack Bogle obviously had this incredible canvas on which he could write his life story.
But, yes, he later on, in his later years, would say that “I didn’t know anything about efficient markets. I didn’t hear about Markowitz or Fama. I was this yokel,” like this poor boy who worked through Princeton, and … He would downplay his own intellect and pretend that he was just this simpleton.
Jack Bogle was brilliant, and he was incredibly well-read. He was a voracious reader of any investment industry news. I know for a fact because I talked to people that met him at the University of Chicago semi-annual seminars on things like efficient markets, and all this jazz. He would try to pretend that he came into index funds almost by accident because he read Paul Samuelson, a famous economist that helped popularize the idea of index funds, but he didn’t know anything about everything else.
It’s, I don’t want to say … I think that stretches credulity. I just don’t think that’s very likely.
Yeah. Of course, it’s also true that this story, told in this way, it’s also easier to sell to the news, to the media, because is the story of the American dream. “Also you can make it. If I could make it as a simpleton,” as you said, “also you could make it.” Definitely telling the story in this way would help him actually shape his own legend, right?
How did Bogle use press coverage to shape his personal story and build his own myth?
Yeah. He was a world-class storyteller. That’s a skill that sometimes gets dismissed, in the same way, “He’s just a salesman. He’s not a brilliant innovator.” Jack Bogle was a brilliant innovator in many respects, but he was, I think, one of the greatest storytellers the investment world has ever seen, up there with Warren Buffet.
That is actually important because he was able to convince people in very simple messages why this is good. I dream to be one basis point as good a storyteller as Jack Bogle was. He’s just phenomenal at this. That was one of the reasons why indexing really helped take off eventually. A lot of the stuff that he wrote and said about how he came into it had more to do with, I think, burnishing the legend of St. Jack, as he became known, rather than the reality of Jack Bogle.
When can we say the index fund, in the modern sense, was born?
Yeah. No, you’ve stumbled across one of my absolutely favorite geeky, nerdy subjects, but yes. Obviously, the first index funds, including Vanguard’s, use the S&P 500 as the shorthand because it was a pretty good reflection of the entire stock market if you weigh it by size. Today Apple is more important for the direction of the US stock market than American Airways or Alaska Airways. The S&P 500, because it captures the 500 biggest-ish companies in America, it is a pretty good shorthand for the entire US stock market.
But, it’s not perfect. Especially in an economy as dynamic as the US, there have always been a lot of smaller companies that grow quite quickly. For a purist of financial economics, like somebody who believes in the theory that underpins this, the S&P 500 is at best an imperfect shorthand, and at worst a very ugly one.
Gus Sauter was one of the people that went into … He was the head of the equity indexing arm at Vanguard. This was in the early ’90s. He was always keen. He had studied at the University of Chicago, and he felt that a true index fund should be the entire market portfolio. That should be all stocks.
He got Jack Bogle’s buy-in to finally do this, where they also included small-caps and mid-caps into one giant index fund that basic invested in all the liquid mainstream stocks in America. That fund now is $1.2, $1.3 trillion. Just this one fund would alone be one of the biggest asset management firms on the planet. It’s a huge success.
One thing I love about this subject is that, if you’re a real purist about the market portfolio the way that Sharpe envisaged it, the market portfolio does not just stock. It’s also bonding. It’s also real estate. It’s also commodities. It’s everything. I think that’s probably one of the next iterations of the index fund revolution, is that we start getting truly multi-asset-class, passive portfolios that are cheap, simple, and commoditized, and you can buy off the rack, as it were.
Would the exchange-traded fund be that kind of monster that was envisioned as a purist or more … What do you think? Or there was already an index fund that represented that vision?
I think today there isn’t. Fundamentally, my idea, I think the Vanguard total stock market index fund is a great example of a one-stop index fund. It was super cheap. I think it costs four basis points a year. Because US companies are so global, it’s obviously just US stocks, but you’re getting a lot of international economic exposure as well.
If you’re a half-decent financial advisor or standalone investor, you can combine that fund with maybe a Vanguard or a BlackRock bond fund index fund, and other things. You can cobble together what is essentially a good approximation for the market portfolio as a whole.
Just maybe as an engineering challenge, I quite like the idea that I know people are working on this, but something that combines both public markets, so there are mainstream stocks and bonds, and real estate, and private debt, private equity, the whole works, so that you get … Basically you could go in and, basically, with a click, buy a fund that does all the asset allocation for you as well.
In reality, there’ll have to be some flavors around that, because, obviously, if you’re 18 years old, you shouldn’t be buying the same portfolios if you’re 80. But I think that’s where we’re heading, that the passive investing revolution is going to come to the asset allocation side as well eventually. It’s starting to, arguably, today.
Yeah. What are some of the key facts of the early years of Vanguard? Especially taking into account the personal story of Bogle, and how he had some health … It really was going through a transition where the company at a certain time was supposed to go to the person that he chose to be the successor, which was Brennan, and then, all of a sudden, things changed.
What happened at Vanguard, when Bogle was to leave and then he came back?
Yeah. It’s fascinating. It was one of the things that … I talked to a lot of people involved in the clash between Jack Bogle and his hand-picked successor, his chosen protege, Jack Brennan. Nobody knows. People know the contours of it, but nobody really knows what was said between those two, because both of them have never said a word publicly about it, and even to their friends. Which I admire as a person, but as a researcher researching my book was a little bit frustrating, at least.
Essentially, yeah. Jack Bogle was a brilliant strategist, a visionary, and also a great salesman and storyteller. Jack Brennan was the yin to his yang. Jack Brennan was the consummate efficiency guy. He was the operation guy. He was the guy that made sure that Vanguard, as it started growing enormously in the ’90s, that the trains arrived on time, that it functioned as an organization.
I talked to friends of both of them who said Jack Brennan could not have done what Bogle did. Jack Brennan would never be the founder of an organization like Vanguard, but Vanguard would not be today what it is if it hadn’t been for Jack Brennan, because he made sure that somebody would implement all of Jack Bogle’s ideas. They worked incredibly well together. They were both incredibly hardworking people.
What happened was that Jack Bogle had a very bad heart. He’d suffered many, many heart attacks. He had a congenital heart defect. Eventually, he was in such bad shape that he was still coming in to work, but he couldn’t walk upstairs. He was in bad shape.
Jack Bogle transitioned the leadership formally. Jack Brennan started running the place anyway, and he was formally named Jack Bogle’s successor as Jack Bogle went to get a heart transplant. There he languished for over a hundred days at the hospital before he finally got a heart. People assumed, “Okay. Then maybe he’ll come back to be chairman if he feels okay,” but nothing more than that.
As it turns out, Jack Bogle was invigorated by this heart. He was fitter than ever, had more energy than ever. He came back as chairman, but kind of acted like he still was obviously the founder who ran the place. By then, Jack Brennan had been running it for many years. They ended up clashing more and more.
Eventually, the board sided with Jack Brennan, and Jack Bogle was … They tried to quietly eject him to be chairman emeritus. Essentially those two men fell out, which, first of all, is tragic for both of them, because they used to be so tight, but also for everybody, frankly, around them. It’s a divorce that still shaped Vanguard a little bit in the culture, the Brennanites and the Bogle true believers, the Bogleheads. Yeah. Maybe the competition drove them to great heights, but I think it’s quite sad that they never made up even before Jack Bogle passed away in 2019.
They never really managed to make up at the end, like the last days of Bogle.
Yeah. Many friends tried to engineer a rapprochement, but they never did.
Wow. All right. If we move forward with the story, of course, there has been an evolution to index funds, which is the exchange-traded fund, the ETF.
Who was a pioneer in the ETF space, which represented an evolution of the Index Fund?
That was a guy called Nate Most that lots of people in the ETF world know about but is kind of unknown outside it. I think it’s quite sad because he was a brilliant guy as well.
He was the head of new products at the American Stock Exchange, which today doesn’t exist anymore. When he was working there in the ’80s and ’90s, was struggling in competition, getting squeezed by the Big Board, is what people call the New York Stock Exchange, the big brother, and the upstart electronic exchange, NASDAQ. The AMEX desperately needed something new to save it, essentially, and Nate Most came up with the idea of tradable index funds.
He actually ironically took the idea to Jack Bogle first, and Jack Bogle hated the idea. He thought the idea of people trading index funds was horrific. Although he really got on well with Nate Most, he basically sent him packing.
But then Nate Most took the idea to State Street, and State Street thought it was a cool, interesting idea. They had by then a pretty vibrant index fund business, mostly for pension plans, insurance companies, and so on. They came up with this new tradable index fund.
Basically, you trade shares in a vehicle. There’s lots of nifty stuff that happens under the hood. It didn’t do incredibly well, to begin with, but now, obviously, this is the ascendant form of investing. It’s grown beyond index funds and passive investing. That’s where most of the money is today. The most actively traded equity security on the planet is the S&P 500 ETF, SPDR.
If you look at the entire world, that’s now, I think, as big as the entire classic, plain vanilla mutual fund industry, and it’s growing far quicker. People are packaging active strategies up in ETFs as well. It all sprung from Nate Most. He’s the father of the ETF.
Of course, Bogle didn’t see the potential in ETF, actually not because he didn’t realize that there could be something huge, just because he thought that, philosophically, they went against what he believed was an investing strategy which was supposed to be … Passive investing is about also holding something potentially forever, not trading it every day, which is what an ETF did.
I’m curious to hear from you, because, of course, when you make the transition between index funds and ETF, the cost structure is very similar to that of index funds, but what makes them successful? Of course, those are flexible instruments, but without the same kind of commission structure, they also get, for instance, for mutual funds, where salespeople can be rewarded widely for the work that they’re doing in selling this stuff.
How did the ETF, for instance, take off? Was there something that helped them to take off in a way that was not expected by players in the industry?
You’re right that most people weren’t incentivized to sell them, commissions, or load fees. They had disappeared for a lot of index funds. Vanguard went no load, or no sales commission, in the ’80s. But then you’re very much dependent on having your own retail salesforce, or word of mouth.
ETFs didn’t really have that, because the AMEX was a stock exchange. They just wanted something that would trade on the floor. The market makers that worked on the floor quite liked this, having it to trade, and there was lots of cool stuff you could do with it. But they’re not going to go around selling it to people in the Midwest.
State Street thought it was a cool project, but they didn’t quite, I think, realize the potential of what they’d helped to invent. Yeah. They didn’t have, really, the buy-in.
I think the reason why … That was why it didn’t really take off immediately. I think the reason why it gradually did is, first of all, a lot of professional investors could see the use of this. Imagine if you’re a hedge fund, and you just want to make a … You think, let’s say, the stock market’s going up next week. You don’t want to buy 20 stocks that reflect the entire stock market and pay commissions on those 20 stocks. Maybe something happens to one of the big ones, and then, actually, you might have gotten the trade right, but still lose money.
You just want to buy the entire exposure. You can do that through index futures, for example, or options, or through an ETF. An ETF was a pretty clean way of making a trade, expressing a trade very quickly, because you just bought it like a stock.
In the same way, if you’re a mutual fund manager, maybe if I work at Wigglesworth Capital, and Gennaro Institutional Investors gives me a big check of money, say, $100 million. I want to invest that pretty quickly, because, for every day I’m sitting on $100 million worth of cash, my performance relative to the market that’s generally going upstarts getting a little bit worse. The cash is a drag on returns most of the time.
Obviously to deploy $100 million in stocks takes quite a lot of time. You want to research. You don’t know where you want to do it. Why not buy the entire equity market exposure whilst you wait? Keep some of your money in an ETF, like SPDR. Institutions were the ones that really embraced it first.
Then the retail side picked up very quickly afterward, especially among financial advisors, because it’s so easy for them. Buying a mutual fund with a load quite often was a little bit tedious, but an ETF could just be bought like a stock. Especially in the era when online trading started, and by the late ’90s started taking off, it was just easy to buy that. I think, today, that’s the revolutionary side. It’s the distribution is so easy.
In the US, ETFs have tax advantages that don’t exist in Europe. I think it’s the distribution. It’s just, you can go onto an app like Charles Schwab, or [PD 00:54:00], or some of the new European ones, and you can just buy an index fund or ETF for zero commission. Whilst if you want to invest in a mutual fund, you quite often have to go through a couple of more steps. I think that’s what’s really changed that, and has really helped ETFs take off in a really big way.
What’s next? What is a trend that you’re looking at which is as interesting as ETF? Or it’s probably still ETF, the big deal so far. Is there an evolution that you’re seeing right now?
Like an index fund 3.0, as it were? I mentioned the idea of asset allocation, that people are getting better at packaging up different things into index funds. I think that’s kind of cool. It appeals to the geek in me, though I don’t know how big it’s going to be.
I think also direct investing or direct indexing gets often talked about as index funds 3.0. This is the idea that, rather than buying … The technology’s now so good, the computers are so good, the trading costs are so low that you can customize the index. Rather than buying an index fund of the 500 biggest stocks in the US, you might want to buy, basically, an index fund minus Facebook, because you hate Facebook. Or minus British Airways or American Airways, if they dumped you from a flight. Or maybe minus JP Morgan, because you work at JP Morgan and you don’t want to double your economic risk. You can do indices with a tweak. You can customize them.
That is growing incredibly quickly, and I think is going to continue to grow. I’m just skeptical that it’s ever going to grow to a scale that is even close to what we see in traditional, plain-vanilla index funds and ETFs. Mostly because most people want an easy life, and they don’t want to sit there and fiddle around with an index.
I think the real big thing is actually how ETFs have gone far beyond their genesis, their birth as passive index trackers, and now become a fund structure that is being used for everything, whether it’s commodities or active strategies. Even the hedge fund strategies can be packaged up into an ETF now. I think that’s going to be really interesting to watch over the next, let’s say, 10 years or so.
What’s next for you? Are you going to write another book? If so, what topic, or what you’re looking for?
That’s a good question. I’m definitely not going to write a book for the next 12 months, I think. This took a fair bit of me over the pandemic, and I think the family would be very unhappy if I start a new big project. Hopefully, I have another book in me.
There are so many interesting, fascinating people and interesting, fascinating subjects in the world of finance that I don’t really feel are that well told. All industries have their jargon, and we talk to each other almost to keep outsiders at bay. But I actually think finance is incredibly important and interesting. I think a lot of the stuff that people hate about finance they’d maybe hate a little bit more, or maybe they’d hate different things if they understood it better.
I do think there’s a lot of stuff I’d like to write. I just need to be cognizant of my kids occasionally wanting to see me, and there only being so many hours in the day.
Yeah. Of course, this might turn hopefully into a movie or series soon. One of my favorite series was definitely Billions. Now we’re missing one about Trillions, so who knows?
Yeah. Exactly. Hopefully. Somebody will hopefully option the book for a movie. Whether it ever becomes one I think is going to be very difficult. But if you have any good ideas for who should play the different characters, then let me know.
Yeah. Again, Billions one was one of my favorite series. There are some characters there that I think would be … Probably use those for Trillions.
Yes. Exactly. No, index fund people, there are a lot of geeks, but there were some pretty big characters in the history of index funds as well that I hopefully was able to show.
Absolutely. Thanks, Robin, for joining this conversation. It was my pleasure.
No, thanks, Gennaro. I loved being on it.
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