The evolution of stock index funds
Forty years ago, the thought of buying a stock index fund was ridiculed. Why would anyone be satisfied with an investment that promised nothing more than the same return as the market?
Later this year, however, US stock index funds may, for the first time, control more in assets than mutual funds run by stock-picking managers trying to deliver better returns than an index like the S&P 500.
The surge in popularity for index funds is a product of their lower fees, better performance and the preaching of John Bogle, the founder of Vanguard Group, which launched the first index mutual fund for individual investors in 1976. Bogle died January 16 at 89 after pushing for years to keep costs down and widen access to index funds.
Initially derided as ‘Bogle’s folly’, index funds have become the default way to invest for so many people that some critics now worry about unintended, market-distorting effects that could ultimately hurt investors and society.
US stock index mutual funds and exchange-traded funds (ETFs) now control close to US$3.6 trillion, according to Morningstar. They have nearly erased the once-massive advantage held by actively managed funds, which currently have a total of US$3.77 trillion in assets.
Last year, investors pumped a net US$206.5 billion into US stock index funds and pulled US$174.1 billion out of actively managed ones. Experts say sometime this year US stock index funds will likely eclipse their rivals in assets. In other categories, such as bonds and foreign stocks, index funds have more catching up to do.
Yes, some actively managed funds do better than index funds every year: 36 per cent did so in the 12 months through June, according to the most recent count by Morningstar. But it can be tough for investors to find the few who can do so repeatedly.
AN EXPENSIVE JOB
Consider an investor who wanted to put some money into the US stock market a couple of years ago. She wanted to find a winner, so she looked only at the actively managed mutual funds ranked in the top half of performance for one-year returns through September 2016.
If she picked one at random, though, she had less than a coin flip’s chance of finding one able to repeat that top-half performance, according to S&P Dow Jones Indices.
That’s not to say that fund managers aren’t skilled at what they do. It’s just that doing such work can be expensive, requiring lots of research and trading costs. Actively managed stock funds kept US$78 of every US$10,000 invested to cover their expenses in 2017, for example. Index funds, meanwhile, kept just US$7, according to the Investment Company Institute.
Because of that difference in expenses, actively managed funds need to perform that much better just to match the after-fee performance of index funds. That’s a high hurdle.
The relentless rise in index funds’ popularity, though, has raised concerns. Even Bogle acknowledged some recently. “Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation,” he wrote in the Wall Street Journal in November. “These will be major issues in the coming era.”
Among the fears, the funds may grow to be too big, in the hands of too few companies.
A trio of companies dominates the index-fund industry: Vanguard, BlackRock and State Street Global Advisors. Critics question whether it’s safe for the stock market to have so many dollars concentrated in so few hands, particularly on such issues as corporate governance.
A company’s board must answer to its investors each year at annual meetings, where shareholders vote on CEO pay, environmental issues and other questions.
Supporters of index funds say they’re long-term investors, and their interests are aligned with corporate-governance issues that promote long-term, sustainable returns.
The funds were also feared as distorting pricing.
An investor who puts US$100 into an S&P 500 fund today is effectively putting about US$3.70 into Microsoft and three cents into Campbell Soup, even if that investor thinks Campbell looks like a better buy. That’s because indexes are weighted by the market size of companies, so the most valuable ones make up the biggest proportions of indexes and the index funds that track them.
But even though US stock index funds may be on the precipice of controlling 50 per cent of all fund investments, they control a smaller share of the overall market. Index funds and ETFs control just over 12 per cent of the US stock universe, BlackRock said in a 2017 report.
That leaves pension funds, hedge funds and others free to push up the stock prices of companies that deserve it and pull down prices for others.
A tipping point exists somewhere, where too much concentration in index funds would distort pricing, but analysts debate how far below 100 per cent that number is.
“Absolutely, under such a scenario, chaos would result,” said Ben Johnson, director of global ETF research at Morningstar. “I think it is ultimately something that will receive ever greater scrutiny, and rightfully so, but even with the growth of indexing, it is still a long way off from being at that level.”
The funds were also feared as being riskier.
Owning an index fund means an investor experiences all the highs and lows of the index. While that feels good when markets are strong, as they have been for much of the past decade, it also exposes investors to the full fury of downdrafts, like the market experienced at the end of last year.
Many actively managed funds claim they’ll hold up better than S&P 500 index funds during a down market. So do some index funds, of course, which say they follow indexes of less-volatile stocks.
In the end, researchers say what matters most in picking a fund may not be whether it follows an index or is run by a stock-picking manager, but how much in fees it charges. Having low expenses is one of the best predictors for success in investing.
It just so happens that index funds tend to have the lowest expenses.