A Pillar of Modern Finance Turns 50

Quick, what is 1 July 2021 the 50th anniversary of?

1. The incorporation of Berkshire Hathaway
2. The first index fund
3. The Dow’s first close above 1000*
4. The founding of the SEC

If you answered Berkshire Hathaway, you were off by only 130 years, depending on when you date the company’s origin.

The Dow closed above 1000 in 1972 and the SEC was founded in 1934.

If you guessed the index fund, you were right: The first index fund debuted on 1 July 1971.

But wait, didn’t Vanguard’s John Bogle launch the first index fund in 1976? To be precise, Bogle — and more on him later — introduced the first index mutual fund that year.

A Little History

Although John “Mac” McQuown, a computer-obsessed Northwestern mechanical engineering grad and Harvard MBA, is generally placed as the protagonist in this story, a number of other characters played leading roles in the development of the first index fund.

James Lorie and Lawrence Fisher’s groundbreaking 1964 study “Rates of Return on Investments in Common Stocks” was a critical influence. McQuown met Lorie who in turn introduced him to Eugene Fama of the University of Chicago Booth School of Business. In 1964, McQuown joined the Management Sciences Division of Wells Fargo in San Francisco. Wells Fargo began to engage the services of the so-called “Chicago Gang” — Fama, Michael C. Jensen, Fischer Black, Merton Miller, and Myron Scholes, among other such distinguished academics.

Around this time, William F. Sharpe was working on the capital assets pricing model (CAPM); Paul Samuelson was showing that stock prices follow a random walk; and in 1970, Fama was writing about efficient capital markets.

Running counter to these theories, “The Case for Mutual Fund Management” appeared in the CFA Institute Financial Analysts Journal in 1960. The author was one John B. Armstrong, which happened to be a pseudonym for none other than John Bogle. Then an employee of Wellington Management Company, Bogle/Armstrong claimed that a fund that buys the market average had “a number of weaknesses,” and that the proposed “unmanaged fund” was destined to fail. How ironic that he later became synonymous with passive investing and the index fund.

Around 1970, the Samsonite Corporation approached the team at Wells Fargo. Samsonite wanted to invest $6 million from its pension program in a fund that would track the market. The fund was designed to track all of the stocks on the New York Stock Exchange. It was equal-, not market-cap, weighted and was a nightmare to manage due to the constant rebalancing effort. Remember, these were the days of manual data collection, desktop adding machines and ticker tape.

A later incarnation focused on the easier task of tracking the S&P 500. But Wells Fargo wasn’t alone. Two other companies, Batterymarch Financial Management and American National Bank, were also developing index funds at this time and using sampling instead of full replication.

The genie was out of the bottle: Index funds started to take off with AT&T, Illinois Bell, Ford, and Exxon among the first significant adopters.

And then Vanguard introduced the first index mutual fund in 1976, proving that John Bogle had an epiphany and that John B. Armstrong just hadn’t seen the light.

Active managers have to constantly prove their worth by “beating the market.” That’s a tall order and difficult to do over an extended period of time. On the other hand, index fund managers have a much easier task delivering the majority of the market return to investors. This they can reliably do at very low cost.

At the end of 2020, $23.9 trillion was invested in mutual funds and $5.4 trillion in exchange-traded funds (ETFs), according to the 2021 Investment Company Fact Book. While most of that money is still actively managed, the indexed share of both of these categories combined has increased from 8% in 2000 to 19% in 2010 to 40% at the end of 2020, by my calculations.

Active vs. Index Assets, 1993 to 2020

While the growth in indexed assets is significant, it doesn’t tell the full story. Flows in and out of the funds show an increasing preference among investors for index funds to the detriment of active managers. Active funds have seen outflows each year since 2014, while index funds have recorded inflows in all but one of those years, a trend that, in fact, dates back to 1993.

McQuown and his fellow trailblazers of yesteryear can certainly be proud of their achievement and the revolution it spawned.

Ten years hence on the 60th anniversary of the first index fund, what do you think the share of index mutual funds and ETFs will be? Let’s touch base in 2031.

* An earlier version of this article stated that the Dow first reached 8000 in 1965. That was in inflation-adjusted terms. The text has been updated for clarity.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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