The invention of index funds and the growth of the middle class

The S&P® 500 is a household name. But few Americans may realize its profound impact on how Americans build wealth.

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If you own a 401(k) retirement savings account or are entitled to a pension from your company, the odds are high that your portfolio or company’s pension fund includes shares in an “index fund.”

Index funds “track” a particular index – such as the S&P 500® – by holding stocks that mirror the makeup of the index. Since their invention in the mid-1970s, index funds have become popular investments for Americans looking for a relatively low-risk, inexpensive way to invest in the market.

Among the best known index funds, for example, are the Vanguard 500, which was the world’s first index mutual fund and still among the world’s largest, and the SPDR® S&P500® – an “exchange-traded fund” (ETF) that trades like a stock.

But what made these investment products possible is the invention of the index itself. In 1923, Standard Statistics (now Standard & Poor’s) published its first stock market index, which covered 233 U.S. companies and was computed weekly. Today, S&P publishes one million different indices, including the S&P 500®. Other countries have also developed their own benchmark indices, such as the Nikkei Index in Japan and the British FTSE 100.

Alex Matturri, Chief Executive Officer of S&P Dow Jones Indices, argues that the concept of indexing is a transformational innovation in the history of finance. Indexed investment products, he says, opened up the stock market to ordinary Americans and “democratized” opportunities to build wealth. According to Matturri, index funds now account for about 12 percent – or more than $2 trillion – of the value of the publicly traded companies in the S&P 500®. This interview has been edited for length.

What  is an index and what does it do?

Matturri: An index is the sum value of the companies that make up the index in whatever proportion the weighting scheme is. Most indices are what we call “capitalization weighted” – meaning that the biggest company in the market is the biggest company in the index.

An index simply measures the market. Indices don’t dictate whether the markets go up or down, and they don’t forecast whether the markets go up or down.

The idea first came out of the publication world from journalists who wanted a way to track markets and a way to explain what was going on in the financial world.

Nowadays, the definition of an index is very broad, but the consistent factors are that it’s rules-based, and it represents what it is that you’re seeking to invest.So you if you want to invest in biotechnology companies, you can create an index of biotechnology companies. The key is that you have consistent rules and that it’s transparent so that anyone who follows the methodology can replicate the index.

What was the theory behind the creation of index funds?

Matturri: The whole index fund industry was developed because of the S&P 500®.

In the early 1970s, the founder of Vanguard, John Bogle, wanted a license to create a fund that tracked the market. At the time, he believed that managers who charged a lot of money for managing portfolios weren’t doing a good job.

He thought a cheaper alternative for people was to invest in the whole market. Don’t try to pick stocks – you’ll make money because the market went up and not because IBM did better than General Motors.

The problem is that the whole U.S. market is 7,000 to 8,000 stocks. It’s not practical.

But the [S&P 500®] index is representative of those 7,000 stocks, and it’s capitalization weighted so that out of those 500 stocks, you get 80 percent of the capitalization of the entire U.S. marketplace without buying all of those other smaller stocks. Since the index represents the marketplace, you’re getting close to a market portfolio if you are invested in an index fund.

Bogle gave people an inexpensive product that gave people exposure to the U.S. equity market. And it was inexpensive because you didn’t have to go out and hire someone to pick stocks – you bought all of them. It was also very transparent. You didn’t have to make any decisions. And it was lower cost because indices don’t have much turnover. You’re not doing a lot of buying and selling.

For an example that hits home in Washington, look at the federal Thrift Savings Plan. It’s probably one of the most efficient, well-run pension schemes in the world. It gives [a limited number of] options, and it’s very low-cost because it only uses index funds. If you’re a government employee, you have access to one of the cheapest ways to save. Most people don’t think about it, but without an index, the federal thrift plan wouldn’t exist.

How does the return on index funds compare to “managed” funds where someone handpicks a portfolio?

Matturri: Our studies and a lot of academic work show that over time, it’s very hard for a particular fund to outperform a particular index on a consistent basis. At year-end 2013, 56 percent of large-cap managers underperformed the S&P 500® over a one-year period, and 80 percent underperformed the index over a three-year period.

Some of it is just the cost structure. A mutual fund has to pay a portfolio manager a lot of money because he’s a stock picker. It also pays analysts, and it has trading costs.

If you buy [a product based on] the index, it’s a transparent, low-cost vehicle, and the market picks the stocks. This doesn’t mean an individual portfolio manager can’t outperform the market, but it’s rare that they can do it consistently over long periods of time.

For investors, that says don’t bother investing in a lot of high-priced products. Invest in something that’s cheap, easy, and transparent. That way, you don’t have to worry about what happens if your manager has a bad day and picks a bad stock.

What about so called “non-transparent active funds,” which are also often labeled “index” funds too? What’s the difference?

Matturri: Anybody can create an index. You don’t have to buy an index from us.

You can create an index by taking an Excel spreadsheet and figuring out what stocks to put in it and what rules you want to base it on. But if you create that index and I’m investing in a fund based on it, how do I know that you’re not manipulating that index to benefit yourself?  If your performance is bad, and you’re losing clients and revenue, what are you going to do to boost performance? Maybe you’ll change the index so it’s easier to beat so you look better.

Look at the LIBOR [rate-fixing scandal], which brought a lot of attention to the industry. LIBOR is an index of bank deposit rates out of London. But people who were using that index were also the ones providing inputs into the index and were manipulating it for other business reasons.

If your mortgage is pegged to LIBOR and on the day you signed up for your mortgage the rate was higher than it should have been, you’re paying the price because of someone else’s manipulation.

From an investor standpoint, we would argue that the index [on which the fund is based] should be from an independent index company that doesn’t hold any interest in the stocks that go into the index or in the level of the index.

From the [regulators’] standpoint, it’s important that the independence of the indices be maintained; that people know that the indices are something you can trust; and more importantly from an operational standpoint that they’re made available to everybody throughout the day and that people have access to the information that’s tied to the index.

What’s important is that there isn’t that question of whether the index is being managed or being published with somebody else’s interest in mind. And from our standpoint, there isn’t any. We’re not an investment manager, we’re not a trader, we’re not an exchange. All we do is publish indices. We make our money from licensing the index – from intellectual property – but we don’t have any incentive in the direction of the index or what companies are in our indices.

What would a world without indices and index funds look like?

Matturri: If you go to India, people buy gold and jewelry. In Latin America, people hold cash because they don’t trust the banks.

If you think of the growth of pension schemes in the U.S. that allow people to retire, it’s because people invested not just in government debt, but in equities. They also diversified, which allowed them to take on less risk.

If you don’t have [these options], you have economies that would be a lot smaller, and you’d have less sophisticated economies. If you couldn’t invest in U.S. markets, who will pay for your retirement? People would have to work longer, assuming they can keep their jobs, or they will rely on the government. We’ll need a bigger Social Security system if people can’t invest on their own. There would be a huge impact if financial markets hadn’t developed the way they had.

[People need to] appreciate the role of indices in the growth of markets and the transparency of markets. People know the S&P 500® as a number on the little ticker you see on the CNBC screen, but they may not understand all that goes into creating it.