Some Final Random Thoughts (5)

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Many years ago, my three children were watching television shortly after we had signed up for cable service.  One of the kids' channels back then was Nickelodeon.  I remember all three of them rushing up to me yelling that the TV was broken.  When I asked them what was wrong, they breathlessly reported that, most importantly, they hadn't done anything to the TV set or the remote control and that there was no color on the picture.  Not necessarily buying their story that they had done nothing wrong, I went to investigate.  I started laughing when I realized that the program they were watching was an old show from the 1950s.  Their jaws dropped when I informed them that the show was one I had watched when I was a child, and that there were no television shows in color at that time.  They were so shocked at this news that, at first, I don't think they really believed me.  We had to alternate between several channels, flipping back and forth between color programming and the old black and white broadcast before they accepted the idea.

I assume older investors (I count myself as one of them) can remember the days before index funds, but younger investors might be surprised to learn that one of the most popular types of mutual funds today, the S&P 500 index fund, is not yet 40 years old.  Our old friend Adam Smith wrote several books in addition to his classic, The Money Game.  One of them, Super-Money, was published in 1972.  In that book, he chronicled several studies at the time which concluded that market averages such as the S&P 500 beat the performance of most professionally managed mutual funds a majority of the time.  The question was how to obtain these results without having to buy all 500 stocks.  Mr. Smith wrote the following:

Of course, you cannot buy a statistically random portfolio, even though your portfolio may have a very random look about it.  And you cannot really buy the Dow Jones average or the Standard & Poor.  If you are going to buy a fund -- or the equivalent slice in a bank-managed common trust -- you have to buy that, and you hope that your fund or your banker is at the top of the list, helping the team against the randoms, and not at the bottom.*

About the same time, Professor Burton Malkiel wrote his first of ultimately ten editions of A Random Walk Down Wall Street and joined Adam Smith's lament as follows:

What we need is a no-load, minimum management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock-market averages and does no trading from security to security in an attempt to catch the winners.  Whenever below-average performance on the part of a mutual fund is noticed, fund salesmen are quick to point out "You can't buy the averages."  It's time the public could.**

An S&P 500 index fund buys the stocks that make up the index in the same percentages as exist in the index.  If, say, IBM represents 5% of the index, then it will be 5% of the fund's stock holdings.  The value of the fund moves in lock step with the index itself, and the stocks held in the fund are changed only when a company is removed from the index and a new company replaces it.

Two banks, Wells Fargo and American National Bank in Chicago, offered such index funds to their institutional clients in 1973.  John Bogle, the founder of investment giant Vanguard Group, was the first to offer an index fund holding the S&P 500 stocks to the investing public in 1975. When it started, the index fund attracted $11 million, which was then, and still is, considered a pittance.  Twenty-four years later, 1999, that index fund had grown to $50 billion.  Combined, Vanguard's family of funds totaled $100 billion that year.   Investors who did not want to pick individual stocks for their portfolio understood that they could inexpensively harness the random movements of the stock market and match its annual averages.  They flocked to the fund.  Today most investment companies include an S&P 500 Index fund in their investment offerings.

Like many investment strategies before it, the Random Walk theory has faded in popularity in recent years.  However, the investment product it generated, the index fund, is alive and well on Wall Street.

*  Excerpt from Super-Money by Adam Smith, copyright 1972, published by Fawcett Popular Library, page 95.

**  Excerpt from A Random Walk Down Wall Street, by Burton Malkiel, copyright 1972, published by W.W. Norton, pages 226-227.

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