The movement to passive investing has been unrelenting. Investors may harbour doubts that the markets are perfectly efficient, but they increasingly act as though they are, and index funds have become their investment of choice. The twentieth century, however, was a different story. The markets were rife with inefficiencies and a number of savvy investors made great profits by exploiting those inefficiencies. But in the process, market anomalies were eliminated – to the point where most investors now feel confident that securities accurately reflect value and they increasingly allocate their money among passively managed index funds.
John Bogle’s Vanguard 500 Index Fund, introduced in 1976, was radically different from the 389 mutual funds that had preceded it. His fund used a “passive” strategy that called for just matching the market, not trying to beat it. He had high hopes that the low cost structure of his fund would have appeal to investors. By just mimicking the Standard & Poor’s 500 Index, investors would avoid the high costs of research analysts, portfolio managers, and traders, and pass the savings on to the fund’s shareholders through low management fees. But investors signed up for only $11 million of the fund’s initial $150 offering. The fund was derided as “Bogle’s Folly” and Edwin Johnson III, head of the Fidelity Fund, said aloud what most competitors likely thought: “I can’t believe that the great mass of investors are going to be satisfied with an ultimate goal of just achieving average returns on their funds.”1
But Bogle forged ahead. Girded by mounting evidence that active investing is unlikely to produce investment results that are any better – and because of their high costs more often worse – than just a passive investing strategy, index investing found growing acceptance.2 By the twenty-first century Vanguard had become the largest fund organisation in the world and today has approximately $3 trillion under management, most of it in index funds.
Other mutual fund organisations, including Fidelity, have followed Vanguard’s lead and now offer a wide variety of index funds, whether through traditional mutual funds or through their close cousins, exchange traded funds (ETFs). The Investment Company Institute calculated that, beginning in 2007, more new investor money was going into index funds than into actively managed funds. And over the following seven years the trend accelerated, with equity index funds receiving a cumulative $1 trillion of new money – while actively managed equity funds experienced withdrawals of approximately $659 billion in the same seven year period.3 And the shift of new money to passive management has not been limited to individual investors. Using ETFs and proprietary strategies, institutional investors are also rearranging their portfolios to emphasise passive investing. For instance, the California Public Employees’ Retirement System (CALPERS), the largest US pension fund, now manages roughly two-thirds of its equity investments through the use of index funds.
More remarkably, perhaps, CALPERS has recently announced that it will no longer make investments in hedge funds and plans to divest the $4 billion it accumulated in those funds since 2002. Hedge funds are the ultimate active investors; their raison d’etre is devising new investment strategies and making investments based on ferreting out investment value that no one else has discerned. But as CALPERS and other institutional investors have learned to their dismay, over the last six years the investment results for the hedge fund industry as a whole – now a $3 trillion asset class – have been inferior to a simple investment in an index fund such as Vanguard’s Balanced Index Fund, structured with the 60% stocks/40% bonds portfolio that pension funds have traditionally utilised.
The twenty-first century is starting out as the age of passive management. But that result, paradoxically, required the development of sophisticated active investing in the twentieth century, during which time security valuation became more scientific and the distortions of market anomalies were largely removed. There were many prominent twentieth century market practitioners who could be recognised as contributing to the development of today’s efficient markets – and many others in government who were instrumental in creating the vital regulatory environment for full disclosure – but the following highlights just a few of the critically important individuals.
By the end of his remarkable life, Benjamin Graham had become known alternatively as the Father of Value Investing or the Dean of Wall Street. Whatever his rightful title, he was one of the greatest intellects to preside on Wall Street. He graduated from Columbia University in just two-and-a-half years and ranked second in his class – but without so much as an economics course to his credit when he landed on Wall Street in 1914 as a prospective bond salesman at the firm of Newburger, Henderson & Loeb. He didn’t have the self-assurance or social contacts needed to deal comfortably with the old-money bond buyers at the trust and insurance companies, so the Newburger partners made him a “statistician,” as research analysts were called at that time.
In that position he made a great deal of money for himself and the Newburger partners by acting on arbitrage opportunities made possible by glaring inefficiencies in the securities markets. In a stock pick that Graham would credit with being “the real beginning of my career as a distinctive type of Wall Street operator,”4 he carefully calculated the value of holdings of the Guggenheim Exploration Company that would shortly be available to the company’s shareholders upon the earlier announced intention to dismantle the holding company and distribute shares of the individual businesses to the stockholders. At the completion of his analysis he determined that the sum of the Guggenheim parts was much greater than the price the Guggenheim stock was selling for in the market. So he entered into a simultaneous purchase of the shares of Guggenheim and the short sale of the appropriate number of shares in companies that Guggenheim owned, including shares in such companies as Kennecott Copper, Chino Copper, and American Smelting.
The Guggenheim transaction turned out to be highly profitable and the youthful Graham described it in hyperbolic terms: “Here was I, a stout Cortez Balboa, discovering a new Pacific with my eagle eye. Imagine!”5 The new ocean that Graham described contained innumerable profitable arbitrage opportunities, along with other “special situations,” in which securities could be purchased at less than their intrinsic value in the event the company was liquidated. Graham’s approach became an early application of what is now called value investing.
After nearly a decade serving as the “lead statistician” at Newburger, Graham left the firm to open his own money management company and formed a partnership with Jerome Newman that lasted for thirty years. During that time the Graham-Newman Corporation invested for its clients according to Graham’s value-oriented style that searched for market anomalies in which the securities of high quality companies could be purchased at bargain basement prices. At its high point in the 1950s, Graham-Newman was managing about $20 million, not a major amount even in those years. If he had run Graham-Newman as a successful but low-profile operation using his profitable investment rules and standards, his name might be little remembered today. But he was at heart more of an academic than an operator, and wanted to spread his ideas on value investing to a larger audience.
He wrote dozens of articles for the Magazine of Wall Street, an influential publication that explained his analytical frameworks, and he gave a series of evening lectures at Columbia University, collectively called Security Analysis. Graham was an engaging teacher and his courses soon were vastly oversubscribed with standing-room only in Columbia’s lecture halls. A young faculty member, David Dodd, faithfully compiled notes from the lectures and in 1934 Graham and Dodd published Security Analysis, a seven-hundred page doorstop of a book that set forth their methodology for determining investment value.
Nothing like Security Analysis had ever been written and, for the adherents of the value approach to investing, nothing has been written like it since. Warren Buffett, who was one of Graham’s students in the early 1950s at Columbia, wrote in the foreword to the book’s sixth edition in 2009 that Security Analysis provided the road map for his own investing and that “there’s been no reason to look for another.”6 As though other endorsements are needed, Barton Biggs, a noted hedge fund investor and the developer of Morgan Stanley’s research department, recalls that when he was first considering a career in securities research, his father gave him a copy of Security Analysis and instructed him to read it from cover to cover. After he did so and returned the dog-eared, underlined book, his father gave him a new one, saying, “Do it again.”7
In the end, of course, Graham’s penchant for explaining his investment techniques and spreading the gospel of value investing conspired against him. By creating a large new supply of researchers imitating his approach through his books and lectures, it became much more difficult to find overlooked securities that were selling at less than their intrinsic value. In a word, the markets were becoming more efficient. By the late 1950s he was having great difficulty finding bargains in the market using the Graham-Newman criteria and in 1958 folded the business while lamenting, “We can look back nostalgically to the good old days when we paid only for the present and could get the future for nothing. Shaking our head sadly we mutter, ‘Those days are gone forever’.”8
Paying only for the present was the bedrock of Graham’s value investing strategy. He had little use for the growing tendency of investors in the 1950s to determine the price they were willing to pay for common stocks based on an assessment of a business’s long-term prospects. He believed that “growth investing” was foolhardy and inevitably based on overly optimistic assumptions as to the rate and duration of earnings growth. But growth investing became accepted in theory and practice. Nowadays it is drummed into every finance student at the business schools that the value of any security is equal to the present value of its future cash flows.
Yet growth investing was beset with its own anomalies. In particular, there was a puzzling and outsized difference between the value that investors placed on the securities of large, well-known companies and the value they placed on small to medium-sized businesses. Just at the time Graham was exiting Wall Street in 1958, two recent Harvard Business School graduates, Bill Donaldson and Dick Jenrette, were in the final stages of forming a company called Donaldson, Lufkin & Jenrette (DLJ) to exploit that difference.
Donaldson and Lufkin took issue with Wall Street’s narrow focus on “the Generals,” meaning large companies such as General Motors, General Electric, and General Mills. They noted that “[T]oday’s ‘Favorite Fifty’ stocks are selling at price-earnings ratios which average 21 times estimated 1959 earnings. Ten years ago these same stocks could have been purchased at prices averaging 7.7 times 1949 earnings.”9 At the same time, much of the rest of the stock market universe – the thousands of publicly traded companies that were not part of the Favorite Fifty – was stuck with 1949-level price-earnings multiples. That was DLJ’s opportunity: to point investors in the direction of these promising, overlooked companies.
Five years after the founding of the firm, a 1964 Business Week feature article on DLJ recounted the firm’s fifty-one basic recommendations and found that the stocks of those small to medium-sized companies performed 50 percent better than comparable investment in shares of the thirty companies making up the Dow-Jones Industrial Average.10 That level of success caught the attention of Wall Street, opening the way for additional research by many others directed towards smaller, growth-oriented businesses – with the effect of substantially eliminating the large company premium in valuation.
Just as the young DLJ founders discovered and exploited a major market anomaly in the stock market, some ten years later, in the early 1970s, recent Wharton graduate Michael Milken believed he had found an unjustified inefficiency in the low-rated corporate bond market. He acknowledged that bonds with credit ratings below BBB, namely those rated BB, B, CCC, and lower, held much greater inherent risks and their purchase demanded more scrutiny and a thorough knowledge of the underlying business. Still he was convinced that the yields on such “junk bonds” – he preferred to call them high yield bonds – were unduly high if one carefully analysed their risk.
Convincing the innately conservative bond buyers of the day on the merits of junk bonds was a hard sell. But if Milken could get an audience, he was able to make a compelling case. In the 1970s the available supply of junk bonds was made up of “fallen angels”: bonds that had once been investment grade – BBB or higher – but which had come upon hard times and had been downgraded by the rating agencies. But through endless hours poring over complex financial statements and industry statistics, Milken (like Benjamin Graham before him) was able to ferret out investment value and safety that had escaped the notice of less conscientious analysts. He could answer every question about the bond issuer’s business prospects and balance sheet, and more importantly, he could paint a convincing picture as to why many of the fallen angels, with their high yields, could provide a very enticing return on investment – and could do so with a much lower level of risk than their bond ratings suggested.
He eventually found many willing ears and in 1973 convinced a bond-oriented mutual fund, First Investors Fund for Income, to switch its orientation from investment grade bonds to high yield junk bonds; as a consequence, First Investors became the best-performing bond fund in America in both 1975 and 1976. With that success and a string of others, Milken had made his case for junk bonds, and, in the process, removed a major market anomaly. He later became caught up in that frenzy of leveraged buyout financings and was charged with market manipulation in the 1980s. But when the dust settled, the junk bond market emerged as a stable, properly priced new asset class which today approaches $2 trillion, and, unsurprisingly, the majority of trading in that class is not in individual bonds but rather through junk bond index funds.
It would be foolhardy to suggest that passive investing will continue unimpeded on its current trajectory. If nothing else, some significant level of engaged active investment is the sine qua non for the construction of a meaningful index fund. It would be equally foolhardy to suggest that each and every market anomaly has been identified and corrected. But it can be fairly stated that the twenty-first century securities markets have achieved a level of efficiency sufficient for investors of any stripe to participate inexpensively through index funds and do so on a fairly even plane with the rest of Wall Street.
About the Author
Edward Morris, PhD, is the author of Wall Streeters: The Creators and Corruptors of American Finance, recently published by Columbia University Press. He is a professor of finance and former dean of the Plaster School of Business at Lindenwood University, and was formerly Executive Vice President of Stifel, Nicolaus & Company. His website is: http://www.edwardlmorris.com/
1. John Bogle, Don’t Count On It! (New York: Wiley, 2011), 376.
2. The reason is ascribed to the “efficient market hypothesis.” And the EMH is based on what is pretty obvious: all market movements occur with new information, and no single individual has a crystal ball that can predict when that new information will occur or what it will be. With millions of investors seeking profitable information on which to trade, and ready to pounce in an instant, it’s not surprising that few if any individuals can consistently outperform the markets.
3. 2015 Investment Company Institute Fact Book, 47.
4. Benjamin Graham, The Memoirs of the Dean of Wall Street (New York: McGraw-Hill, 1996), 144-145.
5. Ibid., 200.
6. Benjamin Graham and David Dodd, Security Analysis, 6th ed. (New York: McGraw-Hill, 2009), xi.
7. Barton Biggs, Hedgehogging (New York: Wiley, 2006), 89.
8. Benjamin Graham, “The New Speculation in Stocks,” Analysts Journal, June, 1958.
9. Common Stocks and Common Sense (New York: Donaldson, Lufkin & Jenrette, 1959), 2.
10. “Courting the Big Stock Buyers,” Business Week, February 22, 1964.