It may seem like a stock picker’s market, but long-term data still backs the buy-and-hold crowd.
A majority of active managers failed to beat their passive benchmarks in the last year and only 11% of large-cap fund managers outperformed over a 10-year period, Morningstar said in a report last week.
That comes as no surprise to Robin Wigglesworth, global finance correspondent at the Financial Times and author of the new book “Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever.”
The book logs the influence of industry legends including Warren Buffett, Vanguard founder John “Jack” Bogle and Nobel Prize-winning economist Eugene Fama on the creation of the index fund and the subsequent explosion of passive investing.
Here’s host Bob Pisani’s interview Monday with Wigglesworth and Simeon Hyman, head of investment strategy at ProShares, on CNBC’s “ETF Edge.” The interview has been lightly edited for clarity.
Bob Pisani: Beginning in the 1970s, index funds started changing the investment world, and then in the 1990s the birth of ETFs further accelerated the indexing revolution. Can you summarize for the viewers why indexing and passive investing has slowly been conquering the investing world?
Robin Wigglesworth: Two things, really: cost and performance. I think everybody knows about the cost side, that index funds, essentially broad, plain-vanilla, market cap-based index funds are a lot cheaper. You can essentially buy broad U.S. stock market exposure for four basis points now, even for free at some brokerages. And then it’s just the performance side, which I think a lot of people still don’t really realize, that in the long run, the index beats the vast majority of professional money managers across virtually every major asset class. In areas like equities, we’re talking 90%, but still, in fixed income and high yield, most fund managers still can’t beat the index in a 15-year performance period.
Pisani: It is rather remarkable, the evidence here. Indexing goes back a very long way. I keep reminding people the Dow Jones Industrial Index started in, what, 1896 with 12 stocks in it? But modern indexing didn’t really start until the S&P 500 was updated in 1956, and what’s interesting — and you talk about this in your book — there was a real problem calculating indexes prior to computers. How do you calculate 500 stocks in an index when you don’t have a computer around? It was a real issue just doing this.
Wigglesworth: I break out into sweats just thinking about the work that people had to do to do this back in the day. I mean, when they first started at the University of Chicago to try and find out what the U.S. stock market’s return [was] in the long run, nobody really knew the answer. It wasn’t until Merrill basically handed a wedge of money to the University of Chicago to find that out, they spent four years going through magazine clippings, spools, everything like that and pieced together what the U.S. stock market yielded in the long run. And that was not until the mid-’60s, really, that we really had an answer to that question. So everything is easier today, but we forget that we all stand on the shoulders of giants that spent a lot of work on this.
Pisani: The evidence that active managers are pretty poor stock pickers really goes back into the 1930s with the Cowles Commission here, but the evidence really started mounting up in the 1970s and the 1980s. And yet active stock picking is still popular as ever. How do you explain that anomaly despite the evidence?
Wigglesworth: Hope springs eternal. I mean, it’s kind of in our nature that nobody wants to settle for mediocrity, really. This was one of the most potent attack lines of people in the ’70s and ’80s when indexing first started to set roots, that who wants to be operated on by a mediocre surgeon? Who wants a mediocre lawyer? You want the best, right? And you want to be the best. So this wasn’t just seen as lazy and passive, it was kind of seen as giving up. I think for a lot of people, it’s still this boring thing. It’s not exciting to say you’re invested in a low-cost, well-diversified Vanguard index fund. That’s not the kind of thing you roll out at parties and you’re the coolest person there. No, you want to talk about the individual stocks you’ve picked, the derivatives you’re trading, the fund manager that’s managing your family’s money. That’s the kind of stuff that’s cool. And that’s, sadly, human nature.
Pisani: It’s one thing to have an index, but one of the things I’ve found amazing is nobody actually had an investible index until Jack Bogle started up Vanguard and created the first S&P 500 fund in 1973. He faced a lot of opposition from people in the industry and even then there were people who thought this was a waste of time. You spent some time explaining that in your book and Jack’s uphill battle to try to figure out how to get people interested in this business.
Wigglesworth: It’s easy to forget, but the Vanguard 500 fund is now one of the biggest investment funds in the world. I mean, it’s bigger than many standalone asset managers. It’s bigger than many sovereign wealth funds. So when it launched in the mid-’70s, it was known as “Bogle’s folly” because it was such an abject failure, just a colossal failure. They thought they might be able to raise [$]300 million at the time and they kept lowering their projections until they thought it might raise [$]20 [million] to [$]30 million. And when it launched, it only raised $11 million, which wasn’t even enough to buy all the stocks in the S&P 500. This goes to show that sometimes from tiny acorns mighty oaks can grow.
Pisani: We know about the oceans of money moving from active to passive management and much of it’s going into ETFs. That’s what we cover here on this show. Is the evidence still supportive that low-cost indexing outperforms active management when fees and expenses are taken into account? Is the evidence still there?
Wigglesworth: Yes. Very much so. Just recently, we had the latest snapshot of active versus passive come out from Morningstar, which is one of the more comprehensive studies of theirs alongside the S&P Dow Jones, and it again showed that the majority of active managers over the last year have failed to beat their benchmarks. … I think the thing to really remember is that the data can change from year to year, but overwhelmingly, less than half manage to beat the index in any given year, and then over any rolling 10-year period that you care to look at, I think the data is around 10%-15% of managers manage to beat the index, and that’s basically what you’d expect from just random chance.
Pisani: Simeon, you’re an old hand in the ETF business. You’re listening to this. Your thoughts on the growth of this ETF business that we cover?
Simeon Hyman: I think I’d like to just share a thought on what maybe you’d call kind of ETF 2.0, which we like to think of as rules-based strategies. So there are some anomalies in the market, things that are persistent patterns over time, and you can capture them in an index, but not necessarily one that’s sort of a plain-vanilla S&P 500. … You know our flagship ticker, NOBL, tracks the S&P 500 dividend aristocrats and those are companies within the S&P 500 that have grown their dividends for 25 straight years. Among the things you’re capturing from that is a little bit of earnings surprise, almost, because every time a company increases its dividend, it’s telling you that its prospects are a little bit better than you might have thought they were because nobody likes to cut a dividend. So this is also part of the ETF revolution, systematic rules-based strategies that have a role to play alongside those market cap-weighted indices like the S&P 500.
Pisani: Robin, Simeon indirectly referenced the smart beta story, and I wonder if I could get some thoughts on that. The investing community has tied itself into pretzels in the last 20 years trying to figure out if there is anything other than just buying standard indexes that might outperform, and as you noted, beginning with Eugene Fama several decades ago, there was some evidence that, for example, small caps tended to outperform over long periods, value tended to outperform. There’s even been other indications that perhaps momentum strategies might outperform. For the average investor, is it worth pursuing these kinds of strategies? Because the minute I bring up, ‘Oh, historically, small cap has outperformed large cap and value’s outperformed growth,’ investors point out in the last 10 years, that hasn’t happened. Do you have any conclusions from your book and your study on this?
Wigglesworth: It’s a great question. And I struggle with this as well because the data’s the data and it does show that there are certain factors that can over time yield market-beating gains. Even Gene Fama, the father of efficient markets, has done seminal work on this. But the problem is that the key is obviously in the long run. And if you’ve been holding a value fund for the past 10-15 years, that feels too long. That’s too painful. And I think the crucial thing is that a lot of investors actually do worse than the markets not just because they try and pick hot stocks or hot fund managers, it’s because they typically bail when something goes wrong or they jump on momentum. So actually, the problem with smart beta is that it can be really hard to hold through those long, painful drawdown periods, which is why, although I am convinced by the weight of the evidence that it does work, I think in practice it’s really hard for investors to capture that because the discipline needed is almost superhuman at times. I mean, think of value investors. The past decade has been awful, right?
Pisani: What’s the conclusion here? It’s still certainly very clear, would you say, that the concept of market timing does not work, that the problem with market timing is that you have to be right twice — you have to be right going in and then on an exit strategy, you have to be right going out? And the probability that you’ll be able to do that consistently over time — not once, but consistently over many, many years — is very small, at least the academic evidence indicates it’s very small. Am I correct?
Wigglesworth: That’s right. And frankly, even practically as well, and I’m sure you’ve talked to tons of investors that will admit this willingly, that they might be phenomenal security selectors, they might be even great at constructing a portfolio, that market timing is essentially a fool’s errand. And even pedigreed active managers I’ve spoken to admit that that is something they do extremely wearily just because the data and the history is pretty grim. And I think every big active manager has some sort of horror story about sometimes getting a call right, but the timing horrifically wrong, or sometimes getting a call wrong, but they just got lucky on timing, for example. So I think it is one of those perils. As Bogle used to say, it’s time in the market rather than timing the markets that matters.
Pisani: The active community has thrown everything at indexing. First it was un-American to go for the average return. Now they’re saying that if too many people go into indexing it’s going to distort the markets somehow. How important is individual stock trading for the health of the market and how much passive investing can the market bear? Or is that a silly question? I get thrown this all the time from the active guys. ‘It’s going to take over, Bob.’
Wigglesworth: I think it’s a valid question to ask. I think it’s important that even though we can celebrate the boons of passive investing and index investing, you’d be mad to not accept that even positive innovation can have negative externality. I think, though, in practice, I am extremely unconvinced by arguments that the market’s efficiency is being eroded by the growth of passive, mostly because, frankly, a lot of active managers throughout history were in practice closet indexers, they just charged money as if they were trading actively but generally hugged the index anyway. I think there are more mutual fund managers than ever before. There are more day traders than ever before. There are still more hedge fund managers in the U.S. than there are Taco Bell managers. I actually checked that data point recently and it’s true. So the idea that somehow the market is dying, I find that a little bit fatuous. But there are other issues around passive that I think we do need to keep an eye on and not be blind to that there could be some problems here and there.
Pisani: Can we put any numbers on this? It’s kind of hard to figure out, but how big is passive investing versus active? Do we have any sense of this overall? ETFs are almost 30% of the volume by share volume in the United States right now, but I’m wondering about the actual dollar value.
Wigglesworth: By assets under management, if you look at the investment industry in the U.S., passive is around half of the U.S. equity investment universe. But actually, of course, there’s lots of shares … that don’t actually trade. If you look at the overall equity universe, it becomes a little bit different. So I’ve tallied up the international and the U.S. and the global numbers on index funds and ETFs, and broadly speaking, there’s around [$]17 trillion in index funds, formal index funds. So then there’s all sorts of in-house strategies as well, big sovereign wealth funds that don’t want to pay and don’t need to pay BlackRock and Vanguard a few basis points, even, to do it. They can do it in house because it’s pretty simple. And by reverse engineering some numbers I got from BlackRock and others, I calculate that there’s probably around $26 trillion in passive strategies, so that’s globally and in both stocks and bonds and a few other asset classes. And that is still a small minority of the global investable tradeable public markets, but it’s grown fast by probably north of a trillion [dollars] a year.