Investors pushing passive investing to new heights – how it all got started

Flows into exchange-traded funds (ETFs) are on a torrid pace to break records in 2017.  With inflows averaging $40 billion a month, or about $1.3 billion a day, ETFs are on pace to capture more than $500 billion of investor funds by the end of the year, easily breaching the $3 trillion threshold along the way. While that still pales in comparison to $16 trillion held by mutual funds, the trend is unmistakable. While a good portion of funds held in ETFs belong to short-term traders, their steady growth over the last decade is attributable to the passive investing movement, which began 41 years ago.

 

A look back at the birth of passive investing

When tracing the roots of the passive investing movement, all roads lead back to its father, the venerable John Bogle, who launched the world’s first index mutual fund on August 31, 1976. Largely dismissed by the investing establishment at the time as “Bogle’s Folly,” the Vanguard 500 (VFINX) has gone on to become one of the largest and best performing index funds in the world. The fund was based on Bogle’s premise that, just by buying and holding the broad stock market, investors would achieve better results than trying to beat it by picking stocks.

 

Inspired by academic-based evidence

Bogle actually formulated his vision while attending Princeton in 1951, writing a senior thesis called “The Economic Role of the Investment Company.” Later research in the 1960s and 1970s, including the Efficient Markets Hypothesis, provided the academic evidence to confirm his premise. But, it was Paul Samuelson, considered the most important economist of the 20th Century, who inspired Bogle. In his paper, “Challenge to Judgment, published in 1974, Samuelson challenged anyone to show him the brute evidence that active managers can outperform the market; and that, if the evidence can’t be found, everyone should own a passive market index.

The following year, Charles Ellis, one of the most revered figures in American investing, came out with the “The Loser’s Game,” which remains a classic investing book to this day. In it, Ellis observed that 90% of the stock market is influenced by professional investors, who have become so skilled, so technologically advanced, that any advantage is competed away. Essentially, it is too difficult to win anymore. The rest of us, he suggests, are amateurs who should not attempt to play the winner’s game of trying to beat the market; rather, play the loser’s game which means avoiding the risks and costs and to just go along for the ride. It’s better to match the market than to constantly underperform by trying too hard to win. That was all Bogle needed to forge ahead.

 

The stealth wealth transfer

It was Nobel Laureate William F. Sharpe who crystallized the notion that active fund managers underperform passive managers simply because of the laws of arithmetic. He summed up his research with the following quote:

After costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar for any time period.

—William F. Sharpe, 1990 Nobel Laureate

 

Kenneth French concluded in a two decade study that the fees charged by active managers amounts to a massive transfer of wealth – to the tune of about $80 billion a year – from investors’ pockets to the bank accounts of fund managers and their companies.

After 41 years, the evidence continues to pour in, bolstering the case for passive investing. Investors have caught on, committing nearly three-quarters of their assets into passive funds. Investors owe a big debt of gratitude to John Bogle and the academics who inspired him.

 

Author: Vitali Butbaev, Velstand Capital Founder
Vitali Butbaev