Book Review: The Origin of the Index Fund

A review of "Trillions" by Robin Wigglesworth.

In 1960, a man writing by the name John B. Armstrong published an article in the Financial Analysts Journal critiquing the emerging academic research behind indexing, the idea that simply buying the entire stock market would outperform professional stock pickers, then the standard in the investing industry.

In one of the greatest ironies in the story of the index fund, the identity of John B. Armstrong was none other than John Bogle, the late founder of Vanguard who brought index funds to the masses and has saved ordinary investors billions of dollars. But while Bogle often gets credit as the father of the index fund, his achievements were only possible because of the work of those who came before him. Bogle may have popularized the index fund, but he didn’t invent it.

A recent book by Financial Times correspondent Robin Wigglesworth called “Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever,” describes the fascinating story behind the creation of the index fund, from the earliest academic research and the daring entrepreneurs that set out to create the first passive investment vehicle to the indexed mutual funds and ETFs that now manage trillions of dollars globally.

While investors today may take passively managed index funds for granted, just 50 years ago the idea that owning the whole market would provide investors with better returns was laughable.

The research that laid the foundation for indexing can be traced back to a forgotten mathematician, Louis Bachelier, born in 1870 in France, who died in obscurity but whose rediscovery ultimately launched the race to create the index fund.

While studying at the Sorbonne, Bachelier took an interest in finance, writing a thesis on applying calculus to stock market probabilities. Because finance was considered an unserious subject at the time, Bachelier struggled to gain recognition, only securing a tenured position later in life before dying in 1946.

Then in 1954, MIT economist Paul Samuelson discovered Bachelier’s PhD thesis. What he found was fascinating. In his thesis, Theory of Speculation, Bachelier explained how stocks seemed to move randomly. Bachelier’s ideas cemented his legacy as the godfather of the index fund and helped spark the academic interest that would eventually lead to its creation.

Before index funds, professional managers would create portfolios by choosing stocks, although the investment industry didn’t even know what the long-term return of stocks was. In 1960, the Securities and Exchange Commission blocked Louis Engel, head of marketing at Merrill Lynch, from running an ad claiming that stocks were a good long-term investment because of the lack of evidence. So Engel set out to find it, enlisting James Lorie and his colleague Lawrence Fisher of the University of Chicago, who took on the task and created the Center for Research in Security Prices (CRSP).

After examining troves of data, the study concluded in 1964 that someone investing in the stock market from 1926 to 1960 would have made about 9% annually on average, even better than the return of bonds. And they made another curious discovery: These stock returns were higher than the average returns of mutual funds, which charged hefty up-front and annual management fees. The data began casting doubt on the competency of investment professionals to pick stocks.

Also in 1960, University of Chicago economist Edward Renshaw and his student Paul Feldstein published a paper advocating for the creation of “an unmanaged investment company” that could capture the average return of the entire stock market. It was this paper that Bogle was responding to when he penned his pseudonymous attack.

But the idea of indexing had one major problem: There was no practical way to actually do it. No indexed investment product existed and no one had yet attempted one. The nascent idea of indexing did not yet have a fund to put its principles into practice.

Beyond Bachelier, three economists, Harry Markowitz, William Sharpe and Eugene Fama, helped shape the early ideas of the random walk and laid the ultimate groundwork for the first index funds.

In 1952 Markowitz’s research concluded that diversification reduced investing risks, an idea which became the foundation for Modern Portfolio Theory. In 1964, Sharpe’s research led to the capital asset pricing model (CAPM) that measured stock returns compared to their volatility, or risk-adjusted returns. Even as index funds were still nearly 10 years away, Sharpe called the optimal portfolio the “market portfolio.”

While the work of Markowitz and Sharpe helped bolster the argument for indexing, it was Eugene Fama that discovered why the market portfolio was optimal. His 1964 paper “The Behavior of Stock-Market Prices” confirmed that stock prices were random and therefore impossible to predict. And his 1970 paper “Efficient Capital Markets” first put forward the idea that markets are efficient and that stock prices reflect all available information.

All this early research received a tepid reception from the investment industry, who naturally wanted to defend the merits of their supposed expertise. For now, the ideas of indexing were confined to academic circles.

Lorie and Fisher began organizing twice annual seminars at the University of Chicago which became a lightning rod for economists, investment managers and academics interested in efficient markets, creating a haven for radical new ideas on the frontiers of investing.

Enter John McQuown. McQuown was one notable attendee and part of a group known as the Quantifiers. He believed in a more scientific approach to investing, using computers to sort through stock market data rather than the approach at the time which was more akin to throwing darts at a board.

McQuown soon attracted the attention of Ransom Cook, then the CEO of Wells Fargo, who gave him a blank check and free reign in heading up a new unit of the bank in San Francisco called the Wells Fargo Management Sciences division, using the CRSP database to create innovations in the finance industry. It would prove one of the most consequential undertakings in financial history. Although they frequently clashed with the rest of the bank, the Management Sciences division began work on an index fund, consulted by the likes of Sharpe, Markowitz, Lorie and Fisher.

To house their new product, they created a new division called Wells Fargo Investment Advisors (WFIA). In July 1971, the pension fund for Samsonite provided an initial investment to an equal-weighted index fund of stocks on the New York Stock Exchange. This first attempt at an index fund proved unmanageable. In November of 1973 they launched another market-weighted fund that tracked the S&P 500, this time proving more of a success.

But McQuown and WFIA weren’t the only ones. Other early versions of the index fund came from American National Bank in Chicago, where Rex Sinquefield, a student of Fama, was hired to do stock research but soon became disillusioned with his work, and Batterymarch Financial Management in Boston, where Dean LeBaron, wanting nothing more than to be first, followed the research to create an indexed product.

At ANB in 1972, Sinquefield proposed the bank start a passive portfolio of stocks that would track the S&P 500. After some hesitation, the board gave him the green light, and in September 1973, ANB converted an existing fund to track the S&P 500.

Meanwhile at Batterymarch, LeBaron and his team began offering an indexed portfolio via separately managed accounts rather than a mutual fund structure in 1973, marketing the product to pension funds. It only tracked half of the S&P 500 and failed to attract investors.

The reaction from the investment industry was overwhelmingly negative. One financial group called index funds un-American. But even these early attempts didn’t look like the index funds we have today, as they couldn’t track every stock in the index due to the costs and complexities of trading. By 1973, Wells Fargo, ANB and Batterymarch had each put together some version of an index fund, although these early iterations were only available to large institutional investors such as pension funds.

It wasn’t until Bogle finally converted to the idea after being pushed out of the top position at Wellington Management Company that the index fund was introduced to the masses. After his ouster, he created a division called Vanguard, at first only an administrative company but with much bigger ambitions, eventually declaring its independence from Wellington.

In August 1976, Vanguard launched the First Index Investment Trust that tracked the S&P 500. Although today one of the greatest success stories in investing, the FIIT bombed and was dubbed “Bogle’s folly.” However, an S&P 500 fund was only a half measure. The early academic research called for a market portfolio, meaning every stock, and the S&P 500 only represented the largest 500 companies, excluding many mid and small sized stocks. So in 1992, Vanguard launched their Total Stock Market Index Fund, fulfilling the original vision of indexing.

“Trillions” shines most when describing this early history of what we now take for granted. It also shows what an uphill battle it was, and one can imagine how it might not have been had this group of renegades not challenged the conventional wisdom. In the end, the research and these figures aligned at the right time to give birth to arguably the most impactful financial invention in modern history. By 2020, an estimated $16 trillion was invested in passively managed strategies.

These events are covered in chapters 2 through 8. The book covers other important developments in chapters 9 through 14. David Booth, who worked under McQuown at Wells Fargo, went on to found Dimensional Fund Advisors with Sinquefield, which began developing small cap and later value funds. Fama’s Three-Factor Model, with Kenneth French in 1992, supplanted CAPM and identified three unique factors for explaining stock returns: the original factor, market beta, along with size and value.

Then there’s the creation of the ETF, an invention that Wigglesworth calls the index fund’s hydrogen bomb moment, expanding the index revolution by even greater magnitudes.

The idea began with Nate Most, the head of product development at American Stock Exchange (Amex), who, in order to save the struggling company, came up with the idea of index funds that were tradable throughout the day. Bogle was not impressed, fearing the idea of a tradable index fund would discourage buy and hold investing, and as long as he stood at the helm of Vanguard, his company would resist the shift toward ETFs. Amex eventually chose the financial firm State Street to launch the product. They would likely have been the first if not for the slow movement of the SEC. In March 1990, the first ETF began trading on the Toronto Stock Exchange. Three years later on January 29, 1993, State Street and Amex’s S&P 500 ETF product, called SPDR, began trading.

The post-McQuown WFIA struggled to maintain their former glory, which called for another path. It started with a merger with Japanese brokerage Nikko Securities in 1990, and later in 1995 a buyout by Barclays Bank in the UK, finally separating from Wells Fargo. The WFIA was now Barclays Global Investors (BGI), and playing the role of State Street for Morgan Stanley, helped launch their first ETF called WEBS, which Morgan Stanley would soon sell to BGI. WEBS later rebranded as iShares in 2000, and in June 2009, in what is called the deal of the century, the investment firm BlackRock purchased BGI and iShares with it, making it the largest asset manager in the world with a staggering $10 trillion today.

The final four chapters get into the growing criticisms of indexing and the heavy concentration of stocks in the big three asset managers: Vanguard, BlackRock and State Street.

Its critics insist index funds concentrate too much wealth among the big asset managers and raise concerns that if everyone indexes, markets will become inefficient, as there will be such few trading that price discovery will become almost non-existent. Most of the money that goes into index funds goes into the companies that already have the greatest market share. Also of concern is the growing power of the indexes themselves to decide which companies, and which countries, make it in an index.

Some criticisms border on hyperbole, with financial analyst Inigo Fraser-Jenkins calling passive investing “worse than Marxism.” But it’s suspect that some of the biggest naysayers have a financial interest in keeping costly active management alive, like Michael Green, a hedge fund and active ETF manager. These concerns seem overblown given the emergence and growing popularity of active ETFs, such as Cathie Wood’s ARK funds.

Whatever its critics say, index funds have saved investors billions of dollars, and that number may rise to $1 trillion in the near future if it hasn’t already. Thanks to the work of a cohort of University of Chicago economists and investment managers who followed the data rather than their gut, ordinary people can invest for their retirements at almost no cost and keep more money in their pockets, all while guaranteeing the average return of the market. There is no doubt the world is better off with index funds.

Anyone who takes an interest in investing and finance will enjoy “Trillions.” The creation of the index fund will go down as one of the most significant and consequential events in financial history, and this book provides a crucial telling of that history.

Early last year, the drivers of the meme stock craze claimed they were sticking it to Wall Street and empowering the little guy. But while many were left holding the bag when GameStop and AMC came back down to earth, the early pioneers of indexing created something with real, lasting power that has helped ordinary investors fight big money managers and keep more money in their pockets.