By Amol Agrawal
In 1975, John Bogle established Vanguard Mutual Fund which offered a new style of investing: index mutual funds. Since then, index funds have transformed the world of personal investments. Although the first mutual fund (MF) to avoid “putting all eggs in one basket” shaped in 1924 (rb.gy/3g51ra). In the 50-year gap between the first MF and the first index fund, we see the development of economic theory around index mutual funds.
In 1950, Harry Markowitz in his doctoral dissertation showed that a diversified portfolio of uncorrelated securities had lower risks than one high-return security. Thus, if one combines high-return uncorrelated securities in a portfolio, one does not achieve high returns but is at lower risk as well. Interestingly, Markowitz’s doctoral committee that included Milton Friedman opined that the dissertation was not economics, mathematics, business administration, or even literature. Portfolio management was not a subject then. After much anxiety and deliberations, Markowitz was awarded a doctorate in economics, noting the work was seminal. The committee’s decision was proven right as Markowitz was awarded the 1990 Nobel Prize in economics along with William Sharpe and Merton Miller for their work in finacial economics.
In 1956, Sharpe, in his doctoral dissertation, worked further on Markowitz’s findings. Markowitz’s theory required one to calculate covariance between pairs of securities. So for 100 securities, one needed 4,950 covariances which required huge computational power that could take days. Sharpe said one need not calculate covariance with all the securities but covariance between a security and the benchmark index, which was named as beta. The high beta stocks are those that gave higher return than the market, termed as alpha but also carrying higher risk. The low beta stocks were the opposite.
Further, Sharpe showed that the expected return on a security is the risk-free rate added to beta times the difference between market return and the risk-free rate (interest paid on government securities). This became the famous capital asset pricing model. Sharpe’s analysis simplified portfolio theory immensely. An investor could always earn market returns by investing in the benchmark index (beta = 1) that is a diversified portfolio of securities. Choosing high beta stocks required either skill or luck or both.
In the 1960s, Eugene Fama added to Sharpe’s research in a series of papers. Fama introduced the efficient market hypothesis (EMH). This concept states that markets are efficient and the current stock prices incorporate all the information. The corollary is that no analysis can predict stock markets. Fama was awarded the economics Nobel in 2013 along with Robert Shiller and Lars Peter Hansen.
The central lesson in the trio’s research is: invest in a diversified low-cost index fund. The benefits of diversification shown by Markowitz could be achieved by any kind of MF. However, Sharpe and Fama’s research showed it is difficult to beat the market portfolio and there is no point in paying fees to a fund manager to beat the market. The passive investing of following the benchmark index is likely to generate higher returns than active investing of trying to beat the benchmark.
Bogle brought this one lesson into practice. Coincidentally, in his undergraduate thesis on the economics of MFs he stressed the need to manage them in an efficient and economical way. In 1975, he launched the first low-cost index fund named First Index Investment Trust (now Vanguard 500 Index Fund). The rest his history. Vanguard not just lowered its expense ratio from 0.68% of new assets in 1975 to 0.09% in 2021 but also pushed the average MF expenses to fall from 0.73 to 0.49. In 1993, index funds called exchange traded funds (ETFs) were listed on stock exchanges to buy and sell them as stocks. They created a revolution of sorts, with around 12,000 ETFs worth $13 trillion trading globally today.
In India, the Unit Trust of India (UTI) launched the first UTI Nifty 50 index fund in 2000, which marked its 25th anniversary recently. The benchmark fund started the first ETF in 2001. In 2007-08, the number of ETFs (including gold ETFs) were 13 comprising 0.6% of total MF equity assets. In the last few years, one has seen a significant rise in passive investing in India. In December 2020, there were 32 index funds and 87 ETFs whose share of total equity assets was 0.5% and 9.2% respectively. In April, the numbers rose to 309 index funds and 253 ETFs with share of 4.1% and 12.5% respectively. The rise is because many innovative index/ETF funds have been offered by both old and new MF firms. There is a huge potential still as share of passive funds’ assets in developed economies is nearly 50%.
Index mutual funds have created a silent revolution in the last 50 years, helping democratise capital markets by providing low-cost options to general investors. In many countries such as India, the revolution has only just begun.
The author is a researcher and blogger.
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