Victor Hugo once said: “There is one thing stronger than all the armies in the world, and that is an idea whose time has come.” The trend by investors away from active and toward passive management of portfolios began in the mid-1970s with the creation of the first index fund.
The trend picked up momentum in the 1980s from an unexpected source: The arrival of high-speed computers. Their ability to access and analyze massive databases gave financial economists the ability, for the first time, to really analyze the performance of active managers. The data was both consistent and compelling: Investment managers who sought to deliver higher-than-market returns by picking individual stocks or timing market fluctuations (i.e., “active” managers) actually delivered poor and inconsistent performance once apples-to-apples comparisons were made. In other words, once their returns were compared against the appropriate benchmark for their holdings (growth, value, small-cap, large-cap, domestic and/or international equities), active managers were consistently underperforming their true benchmarks. Armed with this academic evidence, institutional investors began to adopt passive investing.
The trend toward passive management gained further momentum in 1990 when the Nobel Prize in Economics was awarded to financial economists Harry M. Markowitz, Merton Miller, and William F. Sharpe for their contributions to the body of work known as Modern Portfolio Theory. The major tenet of this theory is that markets are efficient at pricing securities — at least efficient enough to make the practice of active management non- or even counterproductive due to the expenses incurred in the effort. In 1992 the trend accelerated when the American Law Institute rewrote the Prudent Investor Rule incorporating Modern Portfolio Theory into its definition of prudent investing for those with fiduciary responsibility. Since then, many state legislatures have passed legislation that adopts Modern Portfolio Theory as the standard by which fiduciaries invest funds.
Institutional investors have clearly taken notice. W. Scott Simon’s book Index Mutual Fund summarizes well numerous examples. To name a few of Simon’s citations:1
An Intel spokesman explained the change in strategy when it replaced outside advisors with index funds for its $1 billion retirement plans. “Our goal had been to try to outperform the index fund and over the last five years we have failed to meet that goal.”
Kimberly-Clark, had placed 90 percent of its $2 billion pension plan in index funds, estimating that it would save $100 million in investment expenses over the next decade.
The largest US plan, TIAA-CREF (Teachers Insurance and Annuity Association and College Retirement Equities Fund), with over $100 billion in assets, was 70 percent passively invested. Douglas Dial is portfolio manager of the CREF Stock Account Fund, the largest pool of equity money in the world. Dial was formerly a stock-picking manager who had seen the light. “Indexing is a marvelous technique. I wasn’t a true believer. I was just an ignoramus. Now I am a convert. Indexing is an extraordinarily sophisticated thing to do. … If people want excitement, they should go to the racetrack or play the lottery.”
Examples also abound in Pensions and Investments, (P&I) a leading newspaper covering institutional investing, demonstrating passive investing continues to win new adherents:
