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August 01, 2004 at 04:00 AM
For us capitalists, mutual funds may be one of the greatest inventions ever. These unique entities make it possible for a significant portion of the U.S. population to participate profitably in our economic system. In this column, I examine some of the most important stages in the evolution of mutual funds, and the implications those stages have had for advisors and their clients.
At each stage of this evolution, a major development that solved one problem also created a new problem. The good news is that the mutual fund as an investment vehicle has continued to evolve along with our knowledge of what works and what doesn’t. As a result, your ability to give clients the tools they need for a successful investment experience has grown immensely.
The history of the mutual fund dates back to 19th century Great Britain. However, the first major development in mutual funds as we know them today occurred in 1924 with the introduction of Massachusetts Investors Trust, the first open-end mutual fund. Until then, most Americans put their money in banks. Those who did invest had to build portfolios of individual stocks and bonds–a luxury available only to the wealthy.
Mutual funds changed all that by pooling together the capital of thousands of investors, essentially giving more Americans an easy way to participate in the wealth creation that capitalism offers. They also enabled smaller investors to build properly diversified portfolios. They provided more investors with access to professional money managers who, in theory, had superior insights and a better ability to pick stocks and time markets than other investors. This concept of active management was highly appealing at the time. Of course, it also was the only game in town.
Investors were lukewarm toward mutual funds at first, due largely to the 1929 Crash and the Great Depression that followed. Interest started ramping up following passage of the Investment Company Act of 1940, which imposed a wide range of rules and regulations on the funds and gave them broader appeal. Consider that in 1940 fewer than 70 funds existed, with total assets of $500 million. Today, more than 8,100 funds trade, and total assets have soared to $7.5 trillion.
In the industry’s early days, historical market data was sparse at best. Investors had one way to size up fund performance: They compared one fund’s returns to another, and made it their goal to invest with those managers who were better than their peers. Competition was between the managers.
Things started to change during the 1950s as computers with the ability to crunch huge amounts of data came along. That allowed the academic community to do extensive stock market research. Most notably, Roger Ibbotson and Rex Sinquefield in the 1960s documented the returns from different segments of the capital markets going back to 1926.
The result is that investors finally had a standard by which they could evaluate fund managers and ask a previously unanswerable question: Are managers adding any value through their stockpicking and timing decisions over the return that could be earned by owning the market? You can probably guess the answer. It didn’t take long to see that the active managers as a group had failed miserably to add alpha.
The Index Fund Revolution
This discovery caused some of the more enlightened members of the financial services industry to realize that instead of trying to beat the market, a better approach would be to capture the returns the market offered via indexing. But it wasn’t easy to convince the industry that the way it had been doing business for decades was faulty. Despite compelling academic evidence supporting it, indexing as an investment philosophy faced an uphill battle. As John Bogle points out in his book, Common Sense on Mutual Funds, one early adopter of indexing actually earned the “Dubious Achievement Award” from Pensions & Investments in 1972.
Eventually, in the early 1970s, two firms–Wells Fargo Bank and American National Bank–each introduced institutional-class S&P 500 index funds, and indexing was officially launched. Then Vanguard in 1975 brought index investing to the masses with the first retail S&P 500 fund, Vanguard Index Trust. Of course, we’ve all seen the numbers since that time showing how a passive, buy-and-hold strategy that owns the market addresses the rampant underperformance that results from buying and selling the wrong stocks and being in or out of the market at the wrong times. Look at just about any extended time period and you’ll see that the indexers outperformed a majority of the active managers.
