The Mihir Chronicles

Trillions | How a Band of Wall Street Renegades Invented the Index Fund and Changed Finance Forever by Robin Wigglesworth

March 10, 2023

I. Brief Summary

A great deep dive into how passive and active investing such as index funds & ETFs have changed the wealth management landscape. It is written by Robin Wigglesworth who is a well known journalist at Financial Times (FT). He draws a timeline on the evolution of index funds and ETFs. Towards the end, he warns about the limitation of index investing driven both by index funds and ETFs. The industry has done more good than harm, but with a scale at this level, Wigglesworth makes a few cracks known. The book is also filled with history lessons.

II. Big Ideas

  • The wager between Warren Buffett and Ted Seides on favoring index funds against hedge funds sets up the plot for the book. Buffett bet that a fund that tracked the US stock market would beat any group of hedge fund managers over the decade ending in 2018. Protégé Partners chose five funds of funds, Buffett, the Vanguard 500 Index Trust. Ten years later, the Vanguard 500 Index Trust had trounced the funds of hedge funds, 125.8% to 36.3%. Not a single one of the funds bested the S&P 500.
  • According to Mr. Wigglesworth himself, the index fund wasn’t invented on Wall Street. It was invented on college campuses, most notably on the campus at the University of Chicago.
  • From its theoretical underpinnings at University of Chicago to the early attempts at Wells Fargo to the rise of Vanguard (Jack Bogle) and BlackRock (Larry Fink), this book summarizes the history of passive investment industry.
  • Wigglesworth looks at the origination of the idea which came from a French mathematician Louis Bachelier. It was his PhD doctoral thesis, The Theory of Speculation, published in 1900, which essentially explained why markets are hard to beat. Theory of Speculation became a seminal work in the history of finance.
  • With Bachelier’s work as their foundation, a number of academics, mostly at the University of Chicago, went on to perform increasingly rigorous statistical studies that reached the same conclusion—it was nearly impossible to consistently predict the performance of individual stocks. A few others like Cowles and Lorie explained and evidenced that professional active money managers could not outperform the market year over year.
  • The indexing revolution became possible once advanced computing allowed academics to review the performance of active managers vs. the broader market baskets, such as the S&P 500.
  • Students who had been exposed to these concepts eventually made fledgling efforts to launch market tracking investment funds at Wells Fargo, American National Bank and Batterymarch, but the idea didn’t really catch on until it came to the attention of a finance executive named John Bogle.
  • In 1974 he created the Vanguard company and an investment fund that tracked the S&P 500. The Vanguard family of funds are now among the largest investment funds in the world.
  • The industry is now dominated by heavyweights such as BlackRock and State Street, who compete against passive funds.
  • Exchange-traded funds (ETFs) have acquired a high profile in the financial markets. The idea of ETFs came from Nate Most, the head of product development at the American Stock Exchange. ETFs cross the line between passive and active investing.
  • The indexing revolution has likely saved investors billions of dollars in fees and has shaken up the investment industry.
  • The paradox is that index funds have been good for individual investors, but it may not be so good for capitalism. Various studies have shown how passive investing has outperformed active investing across cycles. But increasing presence of passive investing raises fundamental questions on corporate governance and concentration of power in the hands of a selected few.
  • For example, the addition of Tesla to the S&P 500 index in 2020 resulted in the purchase of $51 billion of Tesla stock by the major index funds. This large investment in the company had nothing to do with Tesla’s prospects. The investment was based merely on the fact that the company had been added to the S&P index, which triggered a massive buying spree by the index funds. Simultaneously, the major index funds dump equally large shares of stock from companies that are removed from the indices, which can pose an existential crisis for those companies, their investors and their employees.
  • Another pitfall of index funds serves as an example which rose from the 2018 shooting at Marjory Stoneman Douglas High School. In the wake of an incident, index fund providers, such as Vanguard and BlackRock, were unable to divest stocks of gun manufacturers, prompting calls to boycott them. Similarly, index funds that are not expressly designed for the purpose cannot divest stocks that fail to meet the environmental, social, and governance (ESG) movement’s standards.
  • Classification is another problem. The index constructors assign Amazon to the retail category, while Google and Facebook are deemed to be communications firms. On the other hand, financial payments companies, such as Mastercard and Visa, are classified as technology stocks. Index committees wield additional market power due to the price impact that is felt when a stock is added to or removed from an index.
  • Index funds are rewiring modern finance. But so did mutual funds before them, and the investment trusts before that. Despite all the concerns, the industry is highly dynamic and can withstand the downside of these limitations. There are tools available to minimize the dangers.

III. Quotes

  • Fred Schwed captured the soured view of his industry in a seminal book titled Where Are the Customers’ Yachts?
  • Over the past decade, about 80 cents of every dollar that has gone into the US investment industry has ended up at Vanguard, State Street, and BlackRock.
  • The best long-term results come from buying a big, well-diversified portfolio of financial securities, and trading as little as possible.
  • It is difficult to get someone to understand something when their salary depends on them not understanding it.
  • One of the most puzzling aspects of the investment industry—why most professional money managers seemed to do such an abysmal job.
  • Not only did this gain Sharpe his PhD, but it eventually evolved into a seminal paper on what he called the “capital asset pricing model” (CAPM), a formula that investors could use to calculate the value of financial securities. The broader, groundbreaking implication of CAPM was introducing the concept of risk-adjusted returns—one had to measure the performance of a stock or a fund manager versus the volatility of its returns—and indicated that the best overall investment for most investors is the entire market, as it reflects the optimal tradeoff between risks and returns.