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Replacing Speculation With An Education: Investors Embrace Index Funds

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The war has been long. Much longer than the World Wars of the 20th century, the Vietnam War, the Civil War, and even the war on terrorism. This war started in the early 1960s, when statisticians began digging into stock price data to find trends that they would be able to exploit through trading. To their bewilderment, there wasn’t much to find. At least not something they could practically use on a going-forward basis (you do enough digging you will find something by random chance, i.e., data mining). This led to the development of asset pricing models that attempted to study financial markets in equilibrium, furthering their understanding of how risk and return were related. By the mid-1970s, this foundation of work led to the creation of an entirely new investment experience: the index fund.

Many battles have been waged in this war. Professional active managers have obviously dismissed this body of literature. Jack Bogle, founder of Vanguard, often talks about the early days when index funds were considered “un-American” or the “dumb money.” Today, Vanguard is now the largest mutual fund company in the world and is still setting new asset flow records.

Index Fund Advisors has taken an active role in these battles and is constantly trying to educate investors about the misinformation that is perpetuated by the media about the merits of the active fund community. We believe this effort was born out of asking the question, “What is the truth?” not “What can we sell?” That involves a scientific approach to inquiry, not relying on advertisements. And it seems like investors around the world are starting to fully embrace the ideas that started over 50 years ago.

An article was recently published in Fortune magazine that gave hard numbers on the growth of the index fund versus its active counterpart. The figure below gives some overview.


Source: http://fortune.com/2016/01/27/investment-mutual-funds-index-fund/

Based on data compiled by Goldman Sachs, over the last 20 years, assets in index funds have grown by 12,800% from $55 billion to $7 trillion, which implies a 27% annual growth rate per year. More importantly, the assets in index funds have gained a larger share of the overall mutual fund market, growing from 4% of the entire market in 1995 to about a third of the overall market in 2015. It is amazing to think that 1 in every $3 in the fund management industry is now in index funds. Further, the asset flow trend for index funds since the last financial crisis is indicative of a very positive future for index funds. While net flows into index funds have been a positive $1 trillion, the active fund community has been hemorrhaging assets, having a net negative inflow of $600 billion over the same time period.

The author of this particular article believes that the war is now over and the index fund has won. While we would like to reaffirm this confidence, we do identify the work ahead of us. It isn’t enough to just simply tell investors to invest in index funds. It takes a diligent effort to keep investors tied to their plan coupled with personalized advice to ensure the investor is properly prepared for their individual financial needs. Events like the last financial crisis remind us how crazy things can get and when emotion starts to trump logic. These types of events are expected to happen more than what we would expect by chance. It could happen tomorrow. Our job is to keep investing as objectively as possible while focusing on the long-term. Nonetheless, we are glad to see that some of the greatest ideas developed in our industry are finally gaining traction.