Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever by Robin Wigglesworth

Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever by Robin Wigglesworth

[insightful book on the current state of the stock market; esp. Index funds & EFTs]

The hedge fund industry first emerged in the 1960s but had enjoyed explosive growth over the last decade, and by 2007 managed nearly $2 trillion on behalf of investors around the world. 

Index funds (dubbed as passive investing) are investment vehicles that simply try to mimic an index of financial securities. An S&P 500 index fund buys every single one of the five hundred stocks in the index, exactly according to their relative stock market value—so it buys more of Apple than it does Alaska Air Group.

During his Berkshire Hathaway annual shareholder meeting on May 5, 2017 speech, Buffet said, There’s one more person that I would like to introduce to you today and I’m quite sure he’s here. I haven’t seen him, but I understood he was coming, Buffett said, scanning the audience. I believe that he made it today and that is Jack Bogle . . . Jack Bogle(Vanguard founder) has probably done more for the American investor than any man in the country. Jack, could you stand up? There he is. To thunderous applause, the gaunt but beaming Bogle, dressed in a dark suit and checkered open-neck shirt, stood up, waved to the crowd, and took a small bow toward Buffett and Munger’s podium.

The public universe of index funds stood at almost $16 trillion by the end of 2020, according to Morningstar, a prominent data provider in the investment industry. But many big pension plans and sovereign wealth funds also have huge internal index-tracking strategies or pay an investment group to do it for them outside of a formal fund structure. BlackRock, the world’s biggest money manager, estimated in 2017 that there was another $6.8 trillion in nonpublic passive equity strategies, managed internally or by the likes of BlackRock. Assuming a growth rate similar to the public index fund world, that means that over $26 trillion—and that is likely a conservative estimate—now does nothing more than slavishly track some financial index, whether the S&P 500 for American stocks, the Bloomberg Barclays Aggregate for the US bond market or the JPMorgan EMBI index for developing country debt. The biggest equity fund in the world is now an index fund. The biggest bond fund is as well. The leading gold index fund now holds more of the yellow metal than most central banks, an astonishing eleven hundred tons.

Financial math behind index fund:

A little-known turn-of-the-twentieth-century French mathematician named Louis Bachelier with ideas astonishingly far ahead of their time. Bachelier’s thesis Theory of Speculation is now widely considered one of the seminal works in the history of finance, the first-ever rigorous, mathematical examination of how financial securities appear to move in unpredictable and random ways. Although little appreciated in his own time, Bachelier is today considered one of the great academics of the nineteenth century, the father of a field now known as mathematical finance. 

In 1932, Alfred Cowles (his family-owned Chicago Tribune and owner) set up the Cowles Commission for Research in Economics, with the motto “Science is Measurement. The Cowles Commission would go on to host and support an all-star cast of great economists and financial academics over the years, such as James Tobin, Joseph Stiglitz, Abba Lerner, Kenneth Arrow, Jacob Marschak, Tjalling Koopmans, Franco Modigliani, and Harry Markowitz, several of whom would go on to win Nobel Prizes for work at the commission. In fact, one could argue that in its heyday it was the most influential economic think tank in history.

Success always has many parents, and there are many people who can make a plausible claim to have launched the first index fund, depending on one’s definition. Wells Fargo arguably got there first with its venture for Samsonite. Yet it was a small, unwieldy account rather than a formal fund, and it tracked a cumbersome, equal-weighted NYSE index, leading some of its rivals to claim they got to the promised land first.

The S&P 500, as it was called, despite initially tracking only 425 companies, was calculated by a Datatron computer linked directly to the stock market ticker machines now set up on Wall Street, and could continuously measure the new index. That was a tremendous improvement. By 1962, the S&P 500 was computed every five minutes (and every fifteen seconds by 1986).

In 1973, Sanjoy Basu, a finance professor at McMaster University in Ontario, published a paper that indicated that companies with low stock prices relative to their earnings did better than the efficient-markets hypothesis would suggest. Essentially, he showed that the value investing principles espoused by Benjamin Graham in the 1930s—which revolved around buying cheap, out-of-favor stocks trading below their intrinsic worth—was a durable investment factor. By systematically buying all cheap stocks, investors could, in theory, beat the broader market over time.

Behavioral economists, on the other hand, argue that factors tend to be the product of our irrational human biases. Investors tend to overpay for fast-growing, glamorous stocks, and unfairly shun duller, steadier ones. Smaller stocks do well because we are illogically drawn to names we know well. The momentum factor, on the other hand, works because investors initially underreact to news but overreact in the long run, or often sell winners too quickly and hang on to bad bets for far longer than is advisable.

Nonetheless, the origin story of index investing is still incomplete. If Wells Fargo’s Management Sciences unit was the original Manhattan Project of index funds, most of the subsequent iterations were important but arguably incremental. They mostly consisted of proliferation, of spreading the approach to new corners of the investment world. Vanguard brought it to the masses, and DFA showed that index investing could be done with a twist. But these were still mostly natural evolutionary steps, building on the initial foundations established by Wells Fargo, American National Bank of Chicago, and Batterymarch.

The next stage would be the development of the equivalent of the hydrogen bomb to Wells Fargo’s atomic bomb, a sea change in the history of financial markets, and investing with ramifications that we are still grappling to understand today. Ironically, while Wells Fargo’s crew of economic rock stars had helped develop the first index fund, its next major mutation was engineered by a group of finance industry nobodies.

“I had no idea that, within a decade, the ETF idea [proposed by Most at their meeting] would ignite a flame that would change not only the nature of indexing but also the entire field of investing”, Bogle admitted. “I can unhesitatingly describe Nathan Most’s visionary creation of the ETF as the most successful financial marketing idea so far during the twenty-first century. Whether it proves to be the most successful investment idea of the century remains to be seen”.

Most’s eclectic background also provided the spark behind the invention of what would become known as the ETF. During his travels around the Pacific, he had appreciated the efficiency of how traders would buy and sell warehouse receipts of commodities, rather than the more cumbersome physical vats of coconut oil, barrels of crude, or ingots of gold. This opened up a panoply of opportunities for creative financial engineers.

You store a commodity and you get a warehouse receipt and you can finance on that warehouse receipt. You can sell it, do a lot of things with it. Because you don’t want to be moving the merchandise back and forth all the time, so you keep it in place and you simply transfer the warehouse receipt, he later recalled

The Amex could create a kind of legal warehouse where it could place the S&P 500 stocks, and then create and list shares in the warehouse itself for people to trade. The new warehouse-cum-fund would take advantage of the growth and electronic evolution in portfolio trading and a little-known aspect of mutual funds Stock exchange specialists—the trading firms on the floor of the exchange that match buyers and sellers—would be authorized to be able to create or redeem these shares according to demand. They could take advantage of any differences that might open up between the price of the warehouse and the stock it contained, an arbitrage opportunity that should help keep it trading in line with its assets.

In basic terms, investors can either trade shares of the warehouse between themselves or go to the warehouse and exchange their shares in it for a slice of the stocks it holds. Or they can turn up at the warehouse with a suitable bundle of stocks and exchange them for shares in the warehouse. Moreover, because no money changes hands when shares in the warehouse are created or redeemed, capital gains tax can be delayed until the investor actually sells their shares—a side effect that has proven vital to the growth of ETFs in the United States. Only when an ETF is actually sold will investors have to pay any capital gains taxes due.

Hayne Leland, John O’Brien, and Mark Rubinstein—the founders of the eponymous investment advisory firm LOR—were determined to find another big idea to restore their luster. The trio set about devising something they dubbed SuperShares. The essence was an ingenious but fiendishly complex investment product that would slice and dice the entire S&P 500 into return segments for investors to choose from according to their risk appetite, and trade on an exchange. At its core was something called the Index Trust SuperUnit, which in some respects resembled what would later be known as an exchange-traded fund

On March 9, 1990, the TSE unveiled what would be the world’s first successful exchange-traded fund, the Toronto 35 Index Participation Fund, or TIPS. Although the Canadians might have crossed the line first due to a more relaxed regulator, the design of the first-ever ETF was still inspired by the Amex and State Street Spider team’s frustrating but pioneering work

Seeing Canada copying a US invention and bringing it to life so quickly was grating to SPDR’s supporters. Luckily, they also had a supporter in the SEC’s chairman, Richard Breeden.in December 1992 the SEC finally gave its blessing. ​​Like Vanguard, SPDR didn’t pay sales fees to financial advisors and brokers. That meant they had no incentive to push their clients into the new product. Although it traded like a stock, it didn’t earn banks' underwriting fees either. The situation was so dire that the Amex at one point even considered scrapping it

Not only was SPDR by then a $125 billion behemoth, but it was also comfortably the most heavily traded stock in the world—a source of immense pride to the people who had slogged their way through its creation and troubled early years. SPDR was a product that launched an entire vibrant and still-growing industry.

After a hefty internal debate, the Amex team decided against trying to patent their invention—with seismic consequences. Given SPDR’s public filings, it was easy for rivals to copy the design. 

The index fund revolution had finally won. From its modest, iconoclastic roots, it had now finally established itself in the heart of Wall Street and is now gradually taking over more and more of the investment world. The finance industry may be unpopular, but this has so far been a boon to humankind, with everyone directly or indirectly reaping the benefits through cheaper savings. Just over the past two decades, the cost of a US mutual fund has now nearly halved. Fink compares the impact of ETFs to how Amazon has transformed retail, with lower prices, convenience, and transparency. The asset management industry was never designed for those things. It was designed with opaqueness and complexity, he says.

The ETF has supercharged index funds, yet the ease with which almost any financial security can be packaged inside means that it is now allowing investors to make the same costly mistakes that first nurtured the industry in the first place

In 2000, there were still just 88 ETFs with just $70 billion of assets, compared to over 500 index mutual funds that managed $426 billion, according to data from the Investment Company Institute. A decade later, the number of ETFs had swelled to 2,621, narrowly surpassing the number of index mutual funds, but in money terms still trailing slightly behind the $1.5 trillion that their more conventional, mainstream counterparts managed. By the end of 2020, there were nearly 7,000 ETFs globally with $7.7 trillion of assets, according to the ICI. That is over twice as many traditional index funds tracked by the ICI, in money terms as finally large as their older cousins, and approaching the number of actively managed mutual funds in the United States.

The vast majority of the money is housed inside the big, mainstream ETFs, such as State Street’s pioneering SPDR, or the equivalent S&P 500 ETFs managed by rivals BlackRock and Vanguard. It is also still primarily a US-based industry. 

There are only about forty-one thousand public companies in the world today. In reality, probably only three to four thousand of those stocks are tradable

Nonetheless, the explosion of indices and index funds of various stripes is emblematic of a worrying trend. The best long-term results come from buying a big, well-diversified portfolio of financial securities, and trading as little as possible. Jack Bogle built a vast financial empire around these two basic principles.

The newest trend is for actively managed ETFs. Essentially, they are traditional funds with the usual medley of analysts, traders, and portfolio managers who use the superior ETF structure—tradable and in the United States tax-advantaged—rather than the conventional legal vehicles that have been the norm for most of the post–World War II era.

It is telling that the industry’s Big Three—BlackRock, Vanguard, and State Street—and many of their smaller rivals have eschewed these, concerned that these more niche, complex products may tarnish the entire index fund universe. AFTER A RELENTLESS DECADE, there are signs that the index fund launch bonanza is slowing down. Most major tracts of industry real estate are now utterly and likely permanently controlled by a handful of big players, chiefly BlackRock, Vanguard, and State Street.

The companies that provide financial market indices were long considered humdrum utilities, often started as adjunct businesses to big financial newspapers like the Wall Street Journal, the Financial Times, and Japan’s Nikkei. No one really considered them a big revenue stream. Today, creating benchmarks is a wildly profitable industry in its own right, dominated by its own Big Three—MSCI, FTSE Russell, and S&P Dow Jones Indices. Together, they have a market share of about 70 percent. Collectively, they arguably constitute the most underappreciated power brokers of the financial world.

Quite simply, they have morphed from simple snapshots of markets into a force that exerts power over them—largely thanks to the growth of index funds, which in practice delegate their investment decisions to the companies that create the benchmarks.

Despite its dramatic stock market gains over the past decade, S&P Dow Jones Indices—one of the biggest providers of financial benchmarks—had long refrained from adding Tesla to its flagship index, the S&P 500, for one simple reason: To be included, a company has to be consistently profitable, a requirement that Tesla had struggled to meet. But Tesla’s notching up four consecutive quarters of profits by the summer of 2020 finally made it eligible, with the mere possibility of helping fuel the rally.

Although Tesla would henceforth become an investable company for all fund managers who benchmark their performance against the S&P 500, they at least have a choice whether to buy or not. The trillions of dollars in passive index strategies that slavishly track the index have no option but to acquire stock in the proportion to the company’s weight in the benchmark, whatever the price or attractiveness of Tesla’s business.

Without looking under the hood, many investors may be surprised to learn that State Street and Vanguard’s US technology ETFs—which together manage over $80 billion—don’t actually include Amazon, Facebook, and Google’s parent Alphabet, simply because they are classified as a retailer and communications companies, respectively, by S&P Dow Jones Indices. In contrast, Apple, primarily a maker of physical devices, and credit card companies Mastercard and Visa are classified as technology stocks.

The power of MSCI, FTSE RUSSELL, and S&P Dow Jones Indices is largely over only stock markets. Of even greater and direct importance to countries are their presence and weighting in various influential bond market indices. These may not have the cachet of the brand-name stock market benchmarks bandied about on TV bulletins, but indices like the Bloomberg Barclays Global Aggregate or JPMorgan’s EMBI and GBI-EM are also powerful in their own way

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

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.

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. These days, even Ph.D. economists aren’t guaranteed jobs in asset management, unless they have married their degree with a programming language like Python, which would allow them to parse vast digital datasets that are now commonplace, such as credit card data, satellite imagery, and consumer sentiment gleaned from continuously scraping billions of social media posts.

The result is that every facet of the money management industry is being altered by the advent of index funds. Many financial advisors no longer bet on the latest trendy stock or rock-star fund manager at Fidelity; they put their clients into a mix of index funds. Private banks in Zürich or Singapore are starting to eschew hedge funds in favor of constructing diversified portfolios of ETFs. Even hedge funds themselves increasingly use ETFs to implement their trades.

Although asset management remains a lucrative business, most trends are pointing the wrong away. Fees are under relentless pressure. When Fidelity— which eventually swallowed its misgivings and belatedly jumped into the index fund game—launched the first-ever zero-fee ETF in 2018, it sent tremors through the stocks of rival money managers, as people started to realize that the end game is likely to be cost-free investing, at least for simple, plain-vanilla index funds.

This was the subject of an eye-catching paper by Harvard Law professor John Coates, entitled The Problem of Twelve, where he argued that the mega-trend of passive investing threatened to hand unsurpassed power to just a dozen or so people working inside the index fund giants, the proxy advisors, and a handful of traditional investment groups that will likely continue to thrive. 

Over the past decade, about 80 cents of every dollar that has gone into the US investment industry has ended up at Vanguard, State Street, and BlackRock. As a result, the combined stake in S&P 500 companies held by the Big Three has quadrupled over the past two decades, from about 5 percent in 1998 to north of 20 percent today. Because not all investors actually vote at annual meetings, Vanguard, BlackRock, and State Street account for about a quarter of all shareholder votes, according to a study by Harvard Law School’s Lucian Bebchuk and Boston University’s Scott Hirst.

Assuming that past trends continue, they estimate that the Big Three will account for over a third of all voting shareholders within the next decade, and about 41 percent inside the next twenty years. In this ‘Giant Three’ scenario, three investment managers would largely dominate shareholder voting in practically all significant U.S. companies that do not have a controlling shareholder, Bebchuk and Hirst pointed out in a 2019 paper

https://corpgov.law.harvard.edu/wp-content/uploads/2019/11/John-Coates.pdf