Shift to index investing only in ‘early innings’

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The humble index fund has proved to be a truly transformational financial creation, bringing about a permanent shift in consensus investing wisdom.

When Vanguard introduced the first index mutual fund 40 years ago, it was denounced by Wall Street stock pickers as a tool to embrace mediocrity, and even un-American.

Now, index-tracking funds account for more than 30 per cent of the market. And Vanguard, as the industry's champion of low-cost, passive investing, is the world's largest fund company with $3.6-trillion (U.S.) in assets.

Vast quantities of money continue to forsake actively managed funds in favour of their indexed counterparts, as the market has become attuned to how much fees can affect performance.

And while indexing is now broadly considered an indispensable style for the investing masses, the praise is by no means unanimous.

In one memorable bit of criticism, research firm Sanford C. Bernstein & Co. issued a report in August calling index investing "worse than Marxism," on the basis that it undermines the productive allocation of capital.

"It doesn't sound that different from 40 years ago," said Joe Brennan, the head of Vanguard's global equity index group.

Mr. Brennan spoke to The Globe and Mail about how far indexing has come, and how far it has yet to go. The following is an edited, condensed version of that conversation.

What has made indexing so popular in recent years?

Vanguard has been a big proponent of low-cost investing, and indexing is the purest form of that. Costs matter. We beat the drum on that simple mantra. That low-cost trend is finally taking hold in a real way, over the last five years, across the globe. It happened earlier in the U.S. after the [dot-com] bubble burst. Regulators took an interest in protecting investors. And adviser models changed from commission to fee-for-service. Then it swept to other areas of the world – Australia, Britain – and now there are some winds of change here in Canada.

It also can't hurt that so many active managers seem to underperform their benchmarks.

A lot of talent has gone into the active-manager community, it's gotten better, and they've competed away some of the advantages that might have been there 30 years ago in an age of poorer information. That's going to weed out some of the active managers on the lower end over time.

Has the pendulum swung too far in favour of indexing?

I don't think so. The trend recently has been a big take-up of indexing. But looking at the bigger picture, we're in the early innings.

Indexing could easily get to 50 per cent, if not more than that.

Does passive investing have the potential to interfere with market efficiency?

I see zero evidence of that. In fact, I see the opposite. I see a more efficient market than 20 years ago, by far. If you look at how IPOs and secondary offerings price, it's as efficient as it has ever been. Spreads are narrower.

Is there a role for active management in the portfolio of the average investor?

For the average investor, the core of their portfolio being a low-cost, indexing, broad-market exposure, is probably the right answer. It could be their entire exposure. To express an interest and risk-appetite different than that is fine, but you have to understand what you're getting into. If you're moving away from the market, it's a bet. If you're giving an active manager a portion of your portfolio, you have to understand how they're going to add value over and above the market. And if you're going to do that, don't pay a lot for it. An active manager has to overcome the additional costs that come with a higher-turnover strategy. There are transaction costs, and higher fees. Their alpha – the value added – has to overcome both those costs. That's been the toughest thing for them to do, and I don't think that's changed.

Do current valuations pose any particular challenges for index investing?

Starting valuations, in any framework, are going to be the biggest driver in your forward returns on stocks. Take North America, you see [price-to-earnings ratios] that are higher than the long-term average. But of course you have to adjust that for the unbelievably low interest-rate environment. So we're a bit expensive, but not crazy. Now, if you were able to pick when those valuations would collapse or expand, you could make a lot of money. But I haven't seen too many investors that are good at doing that.