Trillions

1. Passive Investing's Triumph: Buffett's Bet and the Index Fund Revolution

When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.

Buffett's Million-Dollar Wager. Warren Buffett's bet against hedge funds, choosing a simple S&P 500 index fund instead, highlighted the core principle of passive investing: low costs and broad market exposure often outperform expensive active management. Ted Seides, cofounder of Protégé Partners, took the bet, confident that hedge funds' flexibility would win. The index fund's ultimate victory underscored the difficulty of consistently beating the market, especially after accounting for fees.

The Rise of Index Funds. Index funds, designed to mimic a specific market index, have grown exponentially, managing trillions of dollars. This growth reflects a shift in investor sentiment, recognizing the challenges of active management and the benefits of low-cost, diversified exposure. The success of Vanguard, founded by Jack Bogle, exemplifies this trend, offering investors a "fair shake" through cheap passive investment vehicles.

Impact and Controversy. The rise of passive investing has saved investors billions in fees and democratized access to diversified portfolios. However, concerns have emerged about the potential negative implications of concentrated ownership and reduced market efficiency. Some argue that passive investing has grown into a "blob" that is now "in danger of devouring capitalism."

2. Louis Bachelier: The Unrecognized Godfather of Mathematical Finance

So outstanding is his work that we can say that the study of speculative prices has its moment of glory at its moment of conception.

Bachelier's Groundbreaking Thesis. Louis Bachelier, a French mathematician, laid the foundation for modern finance with his 1900 thesis, "Theory of Speculation." He applied probability theory to stock market operations, observing that price fluctuations appear random and unpredictable. His work introduced the concept of a "random walk," suggesting that past price movements cannot reliably predict future ones.

The Random Walk Theory. Bachelier's theory posited that at any given moment, financial securities are priced at a level that investors, on average, consider fair. This implies that markets are efficient, and attempts to "beat" the market are often futile. Bachelier's work was largely ignored during his lifetime but rediscovered decades later, influencing the development of passive investing strategies.

Father of Mathematical Finance. Bachelier's work is now considered seminal in the field of mathematical finance. His thesis provided a mathematical framework for understanding market behavior, influencing subsequent research on efficient markets and passive investing. The Bachelier Finance Society, formed in 2000, honors his legacy through biannual conferences dedicated to mathematical finance.

3. Alfred Cowles and James Lorie: Unearthing the Truth About Market Performance

It is doubtful.

Cowles's Empirical Studies. Alfred Cowles III, heir to a newspaper fortune, conducted early rigorous studies on the performance of investment professionals. His research, published in the 1930s and 1940s, found little evidence that stock market forecasters could consistently outperform the market. Cowles's work challenged the prevailing belief in the ability of active managers to generate superior returns.

Lorie's Comprehensive Data. James Lorie, a University of Chicago professor, led a comprehensive study of long-term stock market returns for Merrill Lynch. The study, completed in 1964, revealed that stocks had historically provided higher returns than bonds, even after accounting for the Great Crash. More importantly, the data showed that the long-term return of US stocks was actually slightly higher than the average returns of investment trusts and mutual funds.

Impact on the Investment Industry. The findings of Cowles and Lorie, along with subsequent research, contributed to a growing skepticism about the value of active management. This skepticism paved the way for the development and acceptance of passive investing strategies, such as index funds. Their work provided empirical evidence supporting the efficient-markets hypothesis and the challenges of consistently beating the market.

4. Markowitz, Sharpe, and Fama: The Academic Trinity of Efficient Markets

Wall Street stands on the shoulders of Harry Markowitz.

Markowitz's Portfolio Theory. Harry Markowitz revolutionized finance with his 1952 paper on portfolio selection. He introduced the concept of diversification, demonstrating how investors could reduce risk by combining assets with different correlations. Markowitz's work laid the foundation for modern portfolio theory, emphasizing the importance of portfolio construction rather than individual security selection.

Sharpe's Capital Asset Pricing Model (CAPM). William Sharpe built upon Markowitz's work, developing the Capital Asset Pricing Model (CAPM). CAPM provided a framework for calculating the value of financial securities based on their risk and expected returns. Sharpe's model introduced the concept of beta, a measure of a security's volatility relative to the market.

Fama's Efficient-Markets Hypothesis. Eugene Fama formulated the efficient-markets hypothesis, arguing that stock prices reflect all available information. Fama's hypothesis suggests that it is impossible to consistently beat the market because new information is quickly incorporated into prices. The work of Markowitz, Sharpe, and Fama provided the academic underpinnings for passive investing strategies.

5. The Quantifiers: Pioneers of Data-Driven Investing

Investment departments are in the midst of such a silent struggle, and it is clear that the revolutionaries are going to win. Their name: the Quantifiers. Their weapon: the computer.

The Rise of Quantitative Analysis. The "Quantifiers" were a group of forward-thinking investment professionals who embraced data and computers to improve investment decision-making. They challenged traditional, subjective approaches to stock picking, advocating for more rigorous, evidence-based methods. These individuals, including John McQuown, Rex Sinquefield, and Dean LeBaron, played a crucial role in the development and adoption of index funds.

CRSP Seminars as a Catalyst. The Center for Research in Security Prices (CRSP) seminars at the University of Chicago served as a hub for the Quantifiers. These seminars brought together academics and investment professionals, fostering the exchange of ideas and the dissemination of new research. The CRSP data, which provided comprehensive historical stock market information, was instrumental in the development of quantitative investment strategies.

From Theory to Practice. The Quantifiers sought to translate academic theories, such as the efficient-markets hypothesis and modern portfolio theory, into practical investment strategies. They used computers to analyze vast amounts of data, identify patterns, and construct portfolios that aimed to mimic or outperform the market. Their work laid the groundwork for the widespread adoption of index funds and other passive investment vehicles.

6. Wells Fargo, American National, and Batterymarch: The Birth of Index Funds

Wells Fargo is a veritable laboratory for the application of the computer to investment work.

Wells Fargo's Pioneering Efforts. John McQuown, William Fouse, and their team at Wells Fargo Investment Advisors (WFIA) launched the first index fund in 1971 for Samsonite's pension fund. This fund, which tracked an equal-weighted index of NYSE stocks, was followed by a more practical S&P 500 index fund in 1973. WFIA's work demonstrated the feasibility of passively managing investments and replicating market returns.

American National Bank's Publicly Marketed Fund. Rex Sinquefield at American National Bank of Chicago launched the first publicly marketed S&P 500 index fund in 1973. Sinquefield's fund provided ordinary investors with access to a low-cost, diversified investment vehicle that tracked the performance of the broad stock market.

Batterymarch's Early Adoption. Dean LeBaron's Batterymarch Financial Management also offered an S&P 500 index product in 1972-73, but found no takers until late 1974. Despite the initial lack of interest, Batterymarch's efforts contributed to the growing awareness of index funds and their potential benefits. These three pioneering efforts laid the foundation for the index fund revolution.

7. Vanguard's Rise: Bogle's Vision and the Index Fund for the Masses

Funds can make no claim to superiority over the market averages.

Bogle's Early Skepticism. John Bogle, founder of Vanguard, initially questioned the merits of index funds. However, his experiences at Wellington Management and his belief in low-cost investing led him to embrace the concept. Bogle's vision was to create a mutual fund company that operated "at cost," returning profits to investors in the form of lower fees.

The First Index Investment Trust. In 1976, Vanguard launched the First Index Investment Trust, the first index fund available to ordinary investors. The fund, which tracked the S&P 500, initially struggled to attract assets and was derided as "Bogle's Folly." However, Bogle's unwavering commitment to low costs and passive investing eventually led to Vanguard's success.

Vanguard's Impact on the Industry. Vanguard's growth and influence transformed the mutual fund industry. Its low-cost index funds put pressure on other firms to lower their fees, benefiting investors across the board. Bogle's advocacy for passive investing helped democratize access to diversified portfolios and challenged the traditional model of active management.

8. Dimensional Fund Advisors: Factor Investing and the Evolution of Indexing

If I had to rank events, I would say CRSP is probably slightly more significant than the creation of the universe.

DFA's Origins and Philosophy. Dimensional Fund Advisors (DFA) was founded by David Booth and Rex Sinquefield, two University of Chicago graduates who embraced the efficient-markets hypothesis. DFA sought to apply academic research to investment management, developing strategies that captured specific risk factors, such as size and value. The company's approach, known as "factor investing," aimed to enhance returns while maintaining a passive, low-cost framework.

Factor Investing and "Smart Beta." DFA's research and investment strategies contributed to the development of factor investing, also known as "smart beta." Factor investing involves tilting portfolios toward specific characteristics, such as value, size, or momentum, that have historically been associated with higher returns. DFA's work challenged the traditional view of indexing as simply replicating a broad market index.

DFA's Influence on the Industry. DFA's success helped popularize factor investing and influenced the development of new investment products. The company's commitment to academic research and its focus on low costs have made it a respected and influential player in the asset management industry. DFA's "boot camps" for financial advisors helped spread the gospel of efficient markets and factor investing.

9. ETFs: The Spider's Web and the Democratization of Investing

You can tell us apart because he can hear and I can see. That’s why we work so well together.

Nate Most and the Birth of ETFs. Nate Most at the American Stock Exchange (Amex) pioneered the concept of exchange-traded funds (ETFs). ETFs are investment funds that trade like individual stocks on an exchange, offering investors intraday liquidity and flexibility. Most's invention combined the benefits of index funds with the tradability of stocks.

SPDRs and the ETF Revolution. The first ETF, the Standard & Poor's Depositary Receipt (SPDR), was launched on the Amex in 1993. SPDRs, which tracked the S&P 500, provided investors with a convenient and cost-effective way to gain exposure to the broad stock market. The success of SPDRs paved the way for the rapid growth of the ETF industry.

ETFs' Impact on Investing. ETFs have transformed the investment landscape, democratizing access to a wide range of asset classes and investment strategies. ETFs have lower costs, greater tax efficiency, and more flexibility than traditional mutual funds. The growth of ETFs has also fueled innovation in the index fund industry, leading to the development of new and specialized investment products.

10. The Power of Indices: Steering Capital and Shaping Corporate Governance

Science is Measurement.

The Growing Influence of Index Providers. The rise of passive investing has given significant power to index providers, such as MSCI, FTSE Russell, and S&P Dow Jones Indices. These companies determine which securities are included in their benchmarks, influencing the flow of trillions of dollars. Index providers' decisions can have a significant impact on companies' stock prices and access to capital.

Corporate Governance and ESG. Index providers are increasingly using their influence to promote corporate governance and environmental, social, and governance (ESG) principles. They are engaging with companies on issues such as board diversity, executive compensation, and climate change. The growing focus on ESG reflects a broader trend toward responsible investing and a recognition of the importance of non-financial factors in long-term value creation.

Concerns about Concentration of Power. The concentration of power in the hands of a few index providers has raised concerns about potential conflicts of interest and the lack of accountability. Some critics argue that index providers may not always act in the best interests of investors or the broader economy. The debate over the role and influence of index providers is likely to continue as passive investing grows.

11. The Future of Finance: Navigating the Challenges and Opportunities of Passive Investing

I would argue that the index fund—first born in the early 1970s—is up there.

The Enduring Legacy of Index Funds. The index fund revolution has transformed the investment landscape, democratizing access to diversified portfolios and lowering costs for investors. Passive investing has challenged the traditional model of active management and forced the industry to adapt. The future of finance will likely be shaped by the ongoing interplay between active and passive strategies.

Challenges and Opportunities. The growth of passive investing presents both challenges and opportunities. Concerns about market efficiency, corporate governance, and the concentration of power need to be addressed. At the same time, passive investing can continue to evolve and innovate, providing investors with new and better ways to achieve their financial goals.

The Importance of Informed Investing. As the investment landscape becomes more complex, it is crucial for investors to be informed and engaged. Understanding the principles of passive investing, the role of index providers, and the potential risks and rewards of different investment strategies is essential for making sound financial decisions. The future of finance depends on investors' ability to navigate the challenges and opportunities of the index fund revolution.

Last updated: April 13, 2025