In 2007, a 36-year-old Wall Street investment manager named Ted Seides took up a bet with the legendary investor Warren Buffett. The Oracle of Omaha, as Buffett is called, had claimed that “a fund that simply tracked the US stock market would beat any group of high-flying hedge fund managers”. Seides took objection to that. The pair agreed a million-dollar wager spanning ten years: Seides would put his money into five actively managed funds-of-funds, while Buffett’s cash went into a fund that simply tracked the S&P 500, an index of shares in 500 large US companies.
There is a reason Buffett is one of the world’s richest men: he is usually right. A decade later, he had achieved a 125.8 per cent return; Seides had managed just 36.3 per cent.
“It wasn’t even close,” writes Robin Wigglesworth, the Financial Times’s global finance correspondent, in his new book Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever. Like Buffett’s investment, index funds track a whole index of companies (such as the Dow Jones or the FTSE 100) or a whole market, such as the London Stock Exchange, rather than having an active manager in charge of choosing which stocks or assets to buy.
Trillions is a history of passively managed index funds, tracking the sector from its beginnings more than a century ago, when a French mathematician named Louis Bachelier wrote a PhD thesis on applying probabilities to stock markets. Bachelier’s book disappeared into obscurity until Leonard Jimmie Savage, a University of Chicago statistics professor, dusted it off in 1954, inspiring a generation of academics. Today, index funds have grown into a $16trn behemoth, and they are still one of the fastest-growing sectors in investment banking.
The central idea of the index fund industry is the efficient markets hypothesis, which holds that the market knows best, because “at any given time, all known, relevant information [is] already reflected in stock prices”. To the investment banking industry, which has made many fortunes from the idea that some people have better information than others, there are few ideas more controversial. The academics, geeks and maverick financiers who created this new sector in the 1970s were usually laughed out of the room when they dared to suggest it.
But as the debate raged through the halls of academia and finance houses, more and more research found that when total returns including dividends are taken into account, passively tracking an index is usually the best way to make money from capital markets. In the 1990s, stock markets began trading shares in exchange-traded funds (ETFs), financial “warehouses” that package together investments in many different assets, and the idea went mainstream.
Unlike many disruptive innovations, index funds haven’t concentrated money in the hands of fewer people. In fact, because they don’t pay for fund managers’ perceived prowess, index funds charge much lower fees than their actively managed counterparts.
The savings are enormous: the 2020 revenue of just one of the large fund managers, Fidelity, is considerably more than the cost to investors of the entire $8trn ETF sector. “The net savings [to investors]… amount to trillions of dollars, money that goes into the pockets of savers, rather than highly paid finance industry professionals,” writes Wigglesworth.
But Trillions is not a love letter to passive investing. In the final quarter of the book, Wigglesworth explores the knock-on effect of the rapid expansion of index funds and ETFs, and the ways in which the industry is beginning to eat itself.
Last November, Tesla’s share price leaped wildly as investors celebrated its inclusion in the S&P 500. Having posted four consecutive quarters of profits, the electric car manufacturer was deemed by the bureaucrats in charge of compiling the index to be ready for inclusion. This meant all the funds and ETFs tracking that index would be forced to buy its shares, and the sudden increase in demand caused a 70 per cent jump in its share price, pushing its already lofty market value over $650bn.
The incident is emblematic of the increasing power of those who compile indices, and those in charge of the funds that track them. “The biggest shareholders in almost every major US company are now index funds, and internationally the trend is heading the same way,” writes Wigglesworth. “There are mounting signs that the index fund tail is beginning to wag the market dog.”
The passive nature of index funds means that while they own large chunks of companies, they don’t tend to do much with their voting rights. One activist shareholder has called passive managers “lazy, inattentive owners, who encourage corporate sloth and waste”. In a financial environment that is beginning to focus on companies’ environmental, social and corporate governance credentials, they may have a point. Trillions is a deft exploration of the resistance encountered by those trying to get passive investment off the ground, followed by the frantic bandwagon-jumping that took place as investors – particularly the fund managers charged with overseeing everyday investors’ money – became comfortable with the idea that it was a cheap and fairly stable way to generate returns. But Wigglesworth comes into his own when he looks at its pitfalls – and the idea that even the best ideas can come undone when they get too big, too fast.
Trillions: How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever
Penguin, 352pp, £25