Part Four

WHAT’S RIGHT WITH INDEXING

Despite the manifest shortcomings that characterize the modern-day mutual fund industry, some mutual funds still offer intelligent investment strategies and policies that allow investors to avoid the pitfalls described in Part Three. My clear choice among these soundly managed funds is the index fund—traditionally based on the Standard & Poor’s 500 Stock Index or the Dow Jones Total Stock Market Index. The index fund is one way—and almost always the best way—for investors to capture their fair share of the returns generated by American business. In Part Four, I expand on the reasons for this certainty.

The role of minimal advisory and management fees is vital. The three other crucial factors are having the broadest possible diversification, the lowest possible portfolio turnover, and the highest possible tax-efficiency that the best index funds offer. It must be obvious that the optimal means of capturing whatever returns the stock market generates is to work in a structure in which the interests of fund shareholders take precedence over the interests of fund managers. (The same principles apply to capturing the returns of the bond market.) Thus, the Alpha structure, previously described in Chapter 12, offers the optimal opportunity for investment success.

I alluded to the idea of a shareholder-friendly structure and its almost-inevitable twin, the index fund, way back in 1951 in my Princeton University thesis. In 2000, I filled in those ideas with considerable detail in “Success in Investment Management: What Can We Learn from Indexing?” (Chapter 17). In it, I lay out the case for passive indexing in some detail and describe the profound impact it will have on the practice of active investment management, though that impact will, sadly, be gradual. (Ironically, one of the two sponsors of the report on which my response was based was brokerage firm Merrill Lynch.) Given the role of costs in creating “negative Alpha” (the margin by which managers lose to the index), I explain why active managers must ultimately adopt strategies focused on lower advisory fees; reduced operating and marketing costs; lower portfolio turnover, leading to minimal transaction costs and maximum tax-efficiency; and the minimization of cash holdings in an equity portfolio, with its accompanying opportunity cost.

In Chapter 18, “As the Index Fund Moves from Heresy to Dogma . . . , ” I describe the growing importance of index mutual funds, and present the intellectual basis for indexing. Years before the market crash of 2007-2009 caused much debate about the validity of the EMH (Efficient Markets Hypothesis), I had the common sense to dismiss it as the explanation of why indexing worked. (Sometimes markets are efficient; sometimes they are not.) In place of the EMH, I offered the CMH (Cost Matters Hypothesis) as mathematical proof that an index of the entire market must and will outperform market participants as a group by the difference in costs. Whether or not markets are efficient, the explanatory power of the CMH holds, at all times and under all circumstances.

Always thinking about profound metaphors to describe my values, I cite the Bible as the source of the title and theme of Chapter 19, “The Chief Cornerstone,” inspired by this sentence from Psalm 118: And the stone that the builders rejected became the chief cornerstone. And so it was with the index fund—from odd outlier to the accepted standard for the measurement of investment returns. I also build on the alliterative “Four E’s” expressed by Warren Buffett: “The greatest Enemies of the Equity investor are Expenses and Emotions.” The index fund battles these enemies and emerges victorious. To this day, it remains the chief cornerstone, a monument that, finally, can be neither shaken nor compromised.

While it took time, the original idea of broad stock market indexing caught hold, and index mutual funds grew from $11 million in 1976 (all in that single pioneering fund) to $637 billion in 2004, and would continue to grow to $1.5 trillion in 2010. That 41 percent annual compound growth rate was far higher than any other sector of the fund industry, a commercial success that accompanied its artistic success in terms of superior returns generated for investors. But during the past decade it has been variations on that original theme that have driven the growth of indexing.

This development is described in Chapter 20, which carries an even longer title than the other chapters in this section: “Convergence! The Great Paradox: Just as Active Fund Management Becomes More and More Like Passive Indexing, So Passive Indexing Becomes More and More Like Active Fund Management.” The final reference is to the development of exchange-traded funds, index funds that offer the ability to “trade all day long in real time” (as some of their advertisements say) and are dominated by ETFs focused on narrow sectors of the market, often highly speculative in nature. Whether that growth will continue, only time will tell. But while it’s easy to see how ETFs serve short-term stock traders, it’s difficult to see how they serve long-term investors significantly more effectively than the classic, low-cost regular index mutual fund.