IN DECEMBER 2009 Paul Volcker, a revered former chairman of the Federal Reserve, took part in a conference on the future of finance. America was plunging into its worst recession since the 1930s, pushed to the brink of disaster by toxic products concocted by Wall Street alchemists. To underline his argument, Mr Volcker made a bold claim: the most useful financial innovation—indeed the only beneficial one—of the past few decades was the automated teller machine, or ATM.
Mr Volcker is right about many things, but wrong on this one. The prize must go to the index fund, pioneered in the mid-1970s by Jack Bogle, who died last week, aged 89.
When Vanguard, the mutual-fund group founded by Mr Bogle, launched its first index fund in 1975 after he had spotted the idea in an article by Paul Samuelson, a Nobel laureate, it was not met with great enthusiasm. Wall Street denounced Vanguard as “unAmerican”. It raised a mere $17m in its first five years. However, in the past decade index investing has grown from a scruffy insurgency into a mainstay of finance. Today index funds are worth around a sixth of the value of America’s stockmarket. In total, Bloomberg reckons, Mr Bogle’s approach may have saved investors $1trn in fees. And still indexation attracts undeserved criticism.
The idea behind it is simple. A mutual fund can mimic the S&P 500 index of leading American stocks. An index fund holds stocks in proportion to their market capitalisation. Because the fund owns all the stocks in the index, it is diversified. Above all, it is cheap to run. It has no need for expensive analysts. Turnover costs are trivial. You buy stocks when they join the index, and sell them when they leave. In between you just hold them.
One charge is that index investing adds to stockmarket volatility and inflates bubbles. This misunderstands the nature of a market-cap index. It weights each stock by its value. If a faddish stock’s price goes up rapidly, its weight in the index increases accordingly, and its value in the indexed portfolio increases automatically. No additional purchase is needed. If anything, index funds make markets less volatile. In panics they have generally been more stable than active funds.
Another change concerns the effect on how well capital is allocated. The case for choosing an index fund rests on the idea that the stockmarket is broadly efficient, in the sense that relevant news about company prospects is reflected in share prices. This depends on the efforts of “active” investors shunning overpriced stocks and buying bargains. Yet as more people invest passively in index funds, might the market become less efficient? And might that create more openings for stockpickers?
That would require active funds to be in a small minority—and they are still far from that. Besides, because index funds probably displace the most inept stockpickers, the market becomes more efficient. By thus taking “dumb” money out of active investing, indexing has made for a keener battle between the remaining stockpickers.
There is a way for active investors to conspire against index funds. The S&P 500 captures most of the value of the stockmarket, but not all of it. So arbitrageurs can make gains by buying stocks that will soon qualify for the index and selling those they will replace. Still, the drag on index-fund performance is modest.
The latest complaint is that, because index funds own sizeable stakes in numerous big firms in each industry, they are a threat to competition. Before he died, Mr Bogle dismissed such charges as “absurd”. Trustbusters are investigating, but the great man may yet be proved right.
Regardless, Mr Bogle should be celebrated as the patron saint of the small investor. Not everyone has the time, patience or skill to run their own stock portfolio. Before he came along, ordinary investors paid a hefty charge for a mutual fund that would usually underperform the market average. Because of him, millions of punters now get the average stockmarket return—and so beat most professionals—for a negligible fee. He was the man who created something supposed to be as rare as hen’s teeth or rocking-horse dung: a useful financial innovation.