Allan Sloan is a seven-time winner of the Loeb Award, business journalism’s highest honor.
There are times when simple numbers tell a big story for investors — and this is one of them.
Today’s numbers involve index funds: Mutual funds that seek to replicate market indicators like the Standard & Poor’s 500 Index or the Nasdaq market or the total U.S. stock market rather than try to outperform them.
For the first time in history, retail investors’ index fund holdings exceed their holdings in actively-managed funds, according to new numbers from Morningstar Direct.
As of March 31, Morningstar says, retail investors had $8.53 trillion invested in index mutual funds, while $8.34 trillion worth of assets were invested in actively-managed funds.
I think of this as Main Street’s revenge on Wall Street. A spokesman for S&P Dow Jones Indices has a more elegant view: “the democratization of investing.”
Back in 1993, when Morningstar first began tracking index-versus-active assets, active funds had about 60 times as much in assets ($1.25 trillion) as index funds ($21 billion).
As recently as 10 years ago, assets invested in index funds by retail investors were only about a third of those invested in actively-managed funds: $1.87 trillion compared to $5.47 trillion. But the tide had long since turned.
By the end of last year, the asset difference was less than one percent — $8.90 trillion to $8.98 trillion. That’s why I recently asked Morningstar to do a special first-quarter analysis for me — and why I wasn’t surprised to see index funds eke out a narrow lead.
Whether you call it revenge or democratization, index assets exceeding active assets is an amazing development, given that active retail mutual funds have been around roughly forever, while retail index funds didn’t exist until 1976. That’s when John Bogle, the late founder of Vanguard Group, got Wall Street to underwrite a tiny $11.4 million issue of what’s now called the Vanguard 500 Index Fund.
After a very slow start — “Who wants to be average?” was how the fund industry attacked Bogle’s baby — index funds, especially low-cost ones, began to catch on. Why? Because year-in and year out, they began to outperform most of the active managers fishing in the same investment waters. And the difference came from lower fees and costs.
Last year, index investors saved $38.6 billion in fees, according to Morningstar’s math, compared to what they’d have paid to have their money in active funds. That’s because the fees on index funds averaged 0.43%, or 43 basis points, less than the cost of active funds. That may be a small percentage difference, but when applied to trillions of dollars, it turns into mega-bucks. Or even giga-bucks.
A major reason for lower costs across the industry comes from Bogle’s insistence on pushing fees lower as Vanguard’s index funds got bigger. That’s due, at least in part, to Bogle setting up Vanguard as a co-op owned by its investors rather than as a conventional investment firm with stockholders seeking to make money off investors.
The initial annual cost to own Bogle’s first retail index fund was 0.20 percent. Now, a retail investor can buy a Vanguard 500 exchange traded index fund that costs only 0.03 percent. And some of Vanguard’s competitors offer even lower costs on some index funds. As data from Morningstar show, fees for index mutual funds not only started from lower levels than their active peers, but have declined faster than active fees over the last several decades.
And now with retail index funds having gotten bigger than actively-managed funds, you can almost hear Bogle cackling from the Great Beyond. Bogle, who died three years ago, had to deal with decades of mockers and scoffers who called index funds “Bogle’s Folly.”
But Bogle talked over and over (and over and over) about what he called “The Triumph of Index Funds” and insisted that they were the wave of the future. Now that the numbers have shown us that’s the case, Bogle is getting the last laugh.
It’s clear that the shrinking of the cost difference between active and passive funds is due, at least in part, to pressure on active managers to improve their funds’ performance relative to index funds. They’ve had to do this because year-in and year-out, most active funds have underperformed the indices, and therefore underperformed index funds.
For example, 85.1 percent of actively-managed large-cap funds underperformed the S&P 500 last year, according to SPIVA data from S&P, which measures the performance gap between actively-managed and index funds. In 2021, some 79.6 percent of all domestic U.S. funds underperformed the S&P Composite 1500, the S&P equivalent of a total market index.
But be aware that although owning low-cost, broad-based index funds is generally better for retail investors than owning active funds or betting on individual stocks, that doesn’t necessarily guarantee smooth sailing. Especially in rocky times like the ones we’re in now.
Jeff DeMaso, director of research for Adviser Investments, says that as of May 10, Vanguard’s S&P 500 Index Fund had dropped by 3.5 percent or more on 67 occasions since 1983. If you bought on those big down days, he says, your average return a year later was about 25 percent. However, he says, on 10 occasions, you were down for the year following the drop.
So although an S&P 500 index fund will likely perform better than equivalent actively-managed funds, it does not guarantee success. But at least you’ll save on fees.