Tracking the Equity Market
February 22, 2021
In the 1960s ideas started circulating about “an unmanaged investment company” which would perform no stock selection and hold stocks in line with their market proportions. Around that time an article in the Financial Analysts Journal noted: “while investing in [an index] would mean foregoing the possibility of doing better than average, it would also mean that the investor would be assured of never doing significantly worse.”
In 1976 John Bogle, founder of Vanguard, launched the world’s first index mutual fund, which tracked the S&P 500. At first it was a slow going. After five years only $17 million had been invested. Since that inauspicious start, the growth of indexes has been mind-Bogleling. By 2020, passive funds accounted for 41% of total mutual fund and exchange traded fund (ETF) assets.
Bogle’s first fund still operates today as the Vanguard 500 Index, with over $100 billion in assets. During this fund’s lifetime, over 200 component stocks of the S&P 500 have been replaced. Removals result from mergers, companies taken private, bankruptcies, or declines in market capitalization. Companies get added when their market capitalizations grow sufficiently large enough. Under current rules, companies must have a market cap of over $9.8 billion and positive earnings over the past four quarters to be eligible for inclusion. Replacement decisions are made by the S&P 500 index committee. As a result, some argue that the S&P 500 is itself not truly passive.
ETFs entered the scene in the early 1990s. Unlike mutual funds, ETFs have the advantage of being tradeable throughout the day. Moreover, ETFs tend to be more tax efficient than mutual funds as they do not create taxable distributions to fundholders by having to liquidate securities to cover redemptions.
By the end of last year, ETFs in the US held nearly $5 trillion in assets. As ETFs have gained popularity, a misconception has developed that all mutual funds are actively managed, while ETFs are passive. The truth is that passive index mutual funds have long existed. Another misconception, that ETFs only track indexes, is also false. In fact, there are innovative ETF structures which allow for active management, although currently they only account for 3% of total ETF assets.
Another option for indexing is to directly own all the components of a target index. This option has been made cheaper by the elimination of trading costs for individual stocks on many trading platforms. Direct indexing provides a greater degree of control over the realization of capital gains and losses. Moreover, an investor can also choose to deviate from the weightings in the index, for example to give more weight to environmental, social, and governance criteria. Of course, direct indexing can be very complicated as it may mean holding hundreds of individual stocks.
In today’s investment universe, investors can customize their portfolios based upon their preferences for passive or active management, and according to the indexes they want to track. Will the trend to passive investing continue? Some argue it is just a trend – time will tell.
Cam Simonds
