Financial History 143 Fall 2022 - Page 22

Hanna Holborn Gray Special Collections Research Center , University of Chicago Library
By Bob Pisani
No one can pinpoint the exact date when it became clear that investing in index funds had won out over investing in active management ( particularly high-cost active management ), but Warren Buffett declaring it to be so was certainly a pivotal moment .
Buffett had entered into a bet with Protégé Partners , a New York City money management firm that runs funds of hedge funds , that an index fund could beat an active manager . The bet was this : over a 10-year period commencing January 1 , 2008 , and ending December 31 , 2017 , the S & P 500 would outperform a portfolio of five hedge funds of funds , when performance was measured on a basis net of fees , costs and expenses .
Buffett , who chose the Vanguard Index Fund as a proxy for the S & P 500 , won by a landslide . The five funds of funds had an average return of only 36.3 % net of fees over that 10-year period , while the S & P index fund had a return of 125.8 %.
University of Chicago Professor James H . Lorie ( left ), director of the Center for Research in Security Prices , with Lawrence Fisher , associate professor and associate director of the Center , 1963 .

ETFs and the Origin of Indexing

In his 2017 letter to shareholders , Buffett took note of the high fees of hedge fund managers and offered what he called a simple equation : “ If Group A ( active investors ) and Group B ( do-nothing investors ) comprise the total investing universe , and B is destined to achieve average results before costs , so , too , must A . Whichever group has the lower costs will win .”
His advice to investors : “ When trillions of dollars are managed by Wall Streeters charging high fees , it will usually be the managers who reap outsized profits , not the clients . Both large and small investors should stick with low-cost index funds .”
Buffett was saying something that had been known to savvy investors and traders for almost a century , but which had taken a long time to seep into the average investor ’ s consciousness .
Unmasking the Wall Street Game
Considering how long the stock market has been around , it took an awfully long time for researchers to figure out that much of the advice Wall Street was giving was bad advice .
Getting hard evidence was not easy in the days before computers . In 1932 , Alfred Cowles III , whose grandfather had founded the Chicago Tribune , conducted an exhaustive survey of 16 financial services that had made 7,500 stock recommendations between January 1 , 1928 and July 1 , 1932 ; 20 fire insurance companies that had picked stocks from 1928 through 1931 ; and 24 financial publications that made market forecasts from January 1 , 1928 to June 1 , 1932 . The results were terrible .
On the track record of the financial services , Cowles concluded that “ Statistical tests of the best individual records failed to demonstrate that they exhibited skill , and indicated that they more probably were results of chance .”
On the track record of the fire insurance companies : “ The best of these records … fails to exhibit definitely the existence of any skill in investment .”
On the track record of the financial publications : “ The most successful records are little , if any , better than what might be expected to result from pure chance .”
A follow-up study Cowles conducted in 1944 also failed to show that stock pickers had any predictive ability . Cowles ’ achievement was notable because of the difficulty he faced in a pre-computer age . Just compiling the data was an immense task .
While the Dow Jones Industrial Average had been around since 1896 , investors did not have a comprehensive stock market database . Absent a database , there was no way a truly comprehensive study of the markets could be conducted .
Mutual Funds Take Off
And that was a problem , because the bull market of the early 1950s ( the S & P 500 was up six out of seven years from 1950 – 1956 ) caused a surge of interest in a then relatively new investment vehicle : mutual funds .
Open-ended mutual funds with redeemable shares had been around since the 1920s . The Securities Act of 1933 , created in the wake of the 1929 stock market crash , required that all investments sold to the public , including mutual funds , be registered with the government . The following year , the Securities Exchange Act of 1934 created the Securities and Exchange Commission ( SEC ) as the primary regulator of securities , including mutual funds . The Investment Company Act of 1940 required even more disclosure
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