Episode 16:

History of the Indexing Revolution

Keith: Welcome to episode 16 of the Empowered Investor. My name is Keith Matthews, and I’m joined by my co-host, Ruben Antoine, for today’s episode. Welcome, Ruben.

Ruben: Hi, Keith. How are you?

Keith: I’m great, thank you. In our last show, we covered the third principle of evidence-based investing, which was to choose index or passively managed investment strategies to almost act like an engine within your diversified portfolio. In today’s episode, we’re going to discuss and explore the origins of the history of indexing. We’ll look at why it took so long for indexing to become this investment revolution that we now speak about today. We’ll discuss why it’s an investment revolution. And finally, we’ll figure out whether Canadians are in fact participating in the indexing revolution. So Ruben, we’re talking a lot about a revolution. Why are we mentioning revolution?

Ruben: Yes, because we believe this invention of indexing was a revolution. When you think of revolution, it’s a new movement. It’s when a group of people or groups go against the norm for a complete change. So when you think about the French Revolution, for example, it was a group of people inspired by hope and dreams of a better society. And we think that there is a similarity that can be done with the invention of ETFs or indexing. So we want to go back in time and speak about those people and about indexing to show the listeners why we think this was a revolution.

Keith: Let’s touch base. Last 20 years in Canada, maybe 20 years in the United States, people are connecting to this concept of buying the index versus buying regular mutual funds, of buying an ETF that tracks a market. And it’s creating a change. I think when you look in the last 10 years, there’s so many things that have changed. There’s digital issues that have changed. There’s the way we shop. We’re now buying on Amazon. In a pandemic, we’re seeing the technology issues move forward. We’re on Zoom. I think that people tend to think that the indexing revolution, anyway in Canada, I think people say it’s probably five to 10 years old. I never really heard about it before. Is it new? And we would always get that question like, “Keith, is this a new thing?” And I think it’s important to go back and review how this revolution, how this change started because it’s not new.

Ruben: It’s not new. And actually, in the world of finance, it was one of the greatest discoveries, the greatest innovations. This is something we think people should know about.

Keith: So I agree 100%. We get back into this sort of where did it start? Ruben, this started in the seventies.

Ruben: Oh my gosh, I was not even born.

Keith: In the seventies, for the listeners that were alive, I would have been seven to 10 years old, but the seventies, if you go back in time, it’s a long time ago, right? You had the U.S. president, since we’re in this sort of presidential change right now, or maybe change or elections, we had Richard Nixon as the president of the United States back then. Geopolitical events were the Vietnam War. There was a lot of turmoil in societies around what societies were supposed to stand for, what freedoms were in place.

Ruben: TV shows.

Keith: Yeah.

Ruben: Tell me a bit about that.

Keith: If you were a kid, you were watching Happy Days, you were watching the Brady Bunch, Get Smart. These were the old class. Have you heard of any one of those?

Ruben: No, no.

Keith: If you were an adult, you might have been watching MASH or the Mary Tyler Moore Show or All in the Family. Have you heard of those shows, Ruben?

Ruben: No.

Keith: This was the 1970s. The end of the 70s, you had inflation of about 10 or 11%. You had really tough times. All that to say that’s now 50 years ago. And this is where indexing started. And when you think about it, there were really four pivotal components that brought together the sort of genesis around starting these concepts because they were not just considered the norm back then. So let’s take a few moments and go over those. And we’re going to speak to that. The four are Fama developed a theory called the market efficiency theory. There were the innovations used early at the institutional level. There was academia that was studying this behind the scenes. And then there was Jack Bogle at Vanguard. So let’s take a few moments now and review these. What was Fama’s discovery, Ruben, and why was it so important?

Ruben: So Eugene Fama was a professor at the University of Chicago. And basically, he brought the idea of the market being efficient. And that idea became the foundation for the development of indexing. He wrote a paper where he showed the hypothesis that the markets are efficient, meaning that for each stock that is being traded in the market, their price gets adjusted very quickly when there is new information. So when you think about the stock market, we have millions of people buying and selling stocks based on the information they have. So that constant competition between investment managers, pension funds, and stock analysts searching for the stocks that they think would outperform is so effective, that competition is so effective that any new information that comes out about a company, they will buy and sell based on this information and the price will go up and down very quickly. So because of this efficiency, it’s very hard. It’s very difficult for anyone to buy a stock that’s going to beat the market. So it’s hard for any active managers to outperform the market by doing active investing. So that was the basis where you start to see that indexing might be a viable investment strategy.

Keith: Yeah, so he didn’t create indexing. What you’re saying is he created the theory that basically said indexing will work.

Ruben: That’s going to be the base to start seeing the, yeah.

Keith: Yeah, his theories were developed and published in 1966.

Ruben: Yes, mid-60s. His paper was written in 1970, but yeah, he started his research in the mid-60s.

Keith: And then he recently, in the last decade, has won a Nobel Prize in Economics for that original work.

Ruben: Exactly, yeah.

Keith: He would be considered the father of indexing.

Ruben: Yeah.

Keith: Which incidentally, when we’re at some Dimensional conferences, we will definitely get a chance to see him and listen to him live in the discussions at the advisor conferences, which is fascinating.

Ruben: Exactly, yeah.

Keith: So what about academia? Why was that important? What was going on there at the same time?

Ruben: At the same time, in the early seventies, academic research started being produced about the whole idea of indexing. And there is a graduate from Princeton University, a Princeton economist, Burton Malkiel. He wrote a book, actually I read that book, A Random Walk Down Wall Street. Very amazing book and highly recommended. And in his book, he basically argues that asset prices, so when you think about stock prices, when they move, they show signs of a random walk. That means that their movement cannot be predicted. And this again became another basis that it’s very hard to outperform to do active investing and achieve better performance. Because when you think about that, if the stocks have a random variation, it’s really hard to predict the movement and to beat the market.

Keith: So his theory or his work added to what Fama did.

Ruben: Yes.

Keith: And so Fama was also academia because he was at the University of Chicago at that point. Fantastic. You’ve got these two pods of energy that are developing, exploring, does indexing work? Can it work? Almost simultaneously, you had within the institutional world a small group of, at that point, it would have been brave investment management groups saying, let us propose to institutions that they give us some money and we will track the index. And that index will be a better solution than actively managed strategies, which are trying to pick winners and not get the losers.

Ruben: So with all this research and all the academic studies, were the institutions, the pension funds, were they adopting the indexing at that time?

Keith: No, not at all. It was just really a few that almost back then took the risk. They may not have carved out a lot of money, but they said, okay, we’ll try this crazy idea of just not really having human beings manage the money. We’re going to track this diversified index and let’s see how it works. The theory suggests it should work, but somebody had to be the first out of the gates and try it.

Ruben: Yeah.

Keith: And so you had the first couple of institutional firms in the United States trying it with the S&P 500. We now know that there are many different indices, small company, large company, global, U.S., emerging market, but they started with the S&P 500 in the early 1970s.

Ruben: But I guess indexing was not available to retail investors yet.

Keith: No, not yet. But that was coming real soon after because you had Jack or John Bogle, who we think now is that fourth main component of this early start of indexing. He also was a university student. He was at Princeton. He wrote his thesis around these concepts of keeping your fees low and that actively managed strategies aren’t in fact going to add value. So he started a company called Vanguard.

Ruben: Yeah. Yeah. I love Vanguard. I’m a big fan of Vanguard.

Keith: And Vanguard was the first retail firm offering to the public access to an S&P 500 index fund. And that was back when? That would be mid-seventies, around 75.

Ruben: Okay. Okay.

Keith: And when he did it, of course, these are individuals that are going against the grain. They are saying that the status quo doesn’t work. They’re saying there’s a better way to manage money and there’s pushback from everybody in the industry. They’re calling them names. They’re doing the bullying. They’re calling them inappropriate strategies. There’s a lot of writings. You hear things like Jack Bogle was considered un-American.

Ruben: Oh my God. This is crazy.

Keith: Not supporting capitalism. So it was tough. But you fast forward to today and Vanguard now manages $6 trillion of assets. It’s a 50-year success story.

Ruben: Yeah. I think Vanguard is the second largest asset manager in the world right now.

Keith: And I believe BlackRock would be number one.

Ruben: Exactly.

Keith: And BlackRock acquired many companies. So BlackRock, the size came from acquisition, whereas Vanguard is 100%, I believe, homegrown.

Ruben: What any listeners may not know, if you’ve heard of Vanguard, that’s one thing, but Vanguard operates like a cooperative. It is a not-for-profit organization, which again was totally un-American. So what does that mean? That means essentially the management fees that investors pay essentially are what it takes to run the company. And profits are not expected to come or be introduced into the management fee.

Ruben: Yeah. Who was bullying Vanguard and Jack Bogle? Was it the industry charging high fees? And is it because Vanguard became a competitor with low fees? Is that the main reason?

Keith: Yeah, absolutely. It has to be. And it was. And it’s the same thing now. If you look at the last 10 years, ETFs are doing the same thing in many regards. The S&P 500, the TSX, you got large, small, you got all these different concepts and it’s the active money managers that are still threatened by it that are poo-pooing it. No different than 1970.

Ruben: Oh man, we are in 2020. It’s the same story.

Keith: Yep. It’s absolutely the same story. Jack Bogle passed away a few years ago. And when he did pass away, one of the quotes I thought was an amazing quote by Warren Buffett. And he did this in his Berkshire Hathaway letter to investors. He mentions, if a statue were ever elected to honor the person who has done the most for American investors, the hands-down choice would be Jack Bogle.

Ruben: Yeah, I totally agree.

Keith: So he’s made this an accessible strategy. He’s empowered the world in terms of getting access to these kinds of low-cost index funds. And he’s not the only one now because there’s lots of firms that are now participating in that.

Ruben: Yeah, it’s funny because even with Vanguard being, like we said, the second largest asset manager, even now when I speak with people and I mention Vanguard, many people don’t know about Vanguard. Vanguard is not the type of company that you will see billboard ads when you’re driving on the highway. They don’t advertise like other big mutual funds companies will do. Investment advisors are not necessarily talking about Vanguard or other ETF providers to their clients.

Keith: You bring up a really good point. When some people say, I haven’t heard of them. They’re not on the radio. They’re not on TV. Like, why are they not on the radio? Why are they not on TV? Why are there not massive billboards promoting all this stuff? What’s your gut feeling?

Ruben: I think it comes down to, if I can say some conflict of interest. Many investment advisors, they will not make as much money if they use Vanguard product with their client compared to some high fees mutual funds. So they are thinking about their own pocket and not the one of their clients. Even if they might think those investment strategies are the best for the investors, they might not propose them to the investors.

Keith: Yeah, that would be why the advisors might not be doing it. I totally agree. Why you don’t see advertising is because these index funds don’t have an advertising budget.

Ruben: Oh, yeah. Yeah.

Keith: So it’s simple. An index fund is expected to keep the cost of the absolute lowest possible.

Ruben: For the benefit of the investors.

Keith: And that is part of the strategy. You cannot add fancy advertising, TV, billboards, and expect to keep your costs down. So there’s a trade-off. This is one of the reasons why you see a little bit of it promoted a little bit more because there’s a bit of a commercialization concept. But throughout the last 50 years, index funds always had no marketing budget, and yet they still managed to become massive and incredibly popular right now. But it’s taken 50 years.

Ruben: Let me ask you that. So we are saying many people don’t know about index funds and ETF, ETF, which is an investment vehicle to access index funds like Vanguard is offering. So many people don’t know about that. There is massive success for a company like Vanguard being now managing $6 trillion. So how do you think Vanguard managed to do that? I know it took a longer time, but how do you think they managed to do that?

Keith: I just think it’s a 50-year story and it’s success. It wasn’t just created in one decade. It took living through many bear markets for investors to realize this strategy works. It really took 2007 and 2008.

Ruben: Exactly. That was the trigger point, right?

Keith: That was the trigger point. And that trigger point really was the time where investors sat back and said, I used to have this tremendous amount of confidence in the advisory community, in the active community, because they somehow knew where the market was going to go.

Ruben: Exactly.

Keith: They were supposed to be the ones that, that’s what they do. That’s how they’re paid. They’re paid to figure. The reality, the problem is investment advisors or investment firms cannot predict the future.

Ruben: Yeah. I think you have a very good point because the selling points of many investment managers is like, when a crisis is coming, I will be able to see it in advance and take your money out of the market and move things around. And people realized in 2008, 2009, and lately with the COVID crash as well, that those promises, those investment managers, they are not able to necessarily do it. They will say they can do it and they will go down as well as much as the market. So people are realizing they don’t need to pay the high fee to hire those people when they are not doing what they’re supposed to do.

Keith: Exactly. And so there’s moments in time throughout the eighties and nineties. Indexing in Canada was not available until we had the participation units that were launched on the Toronto Stock Exchange. That was the TIPS and the HIPS, the Toronto Stock Exchange top 35 companies. You bought a basket and the HIPS, which were the top 100. Incidentally, those were the first two exchange-traded funds in the world.

Ruben: In Canada.

Keith: Created in Canada.

Ruben: Created in Canada.

Keith: And the rest of the world, SPDRs, which was soon after created, used the Canadian participation units as a model. Really in the 1990s, you had Vanguard, which was a mutual fund company. And then you had three or four exchange-traded funds, two of which were in Canada and a couple of the United States. The big ones in the United States were the SPDR on the S&P 500, QQQ, which was on the NASDAQ. You had the mid-cap SPDR and you had a couple of exchange-traded funds called the WEBS, which were international-based. And it wasn’t really until 1999. This is a very important moment in the exchange-traded fund and indexing world. So that’s 20 years ago, 21 years ago. 1999, global money managers had approached these stock exchanges and said, we will take over the world, the exchange-traded. We’d like to buy the units out and we will now start creating them. They licensed indexes from various index manufacturers, which then allowed them to, instead of overseeing four or five exchange-traded funds, it allowed them to start overseeing hundreds of exchange-traded funds. And that’s when the exchange-traded fund industry was truly created.

Ruben: For retail investors.

Keith: For retail investors.

Ruben: And that was the start.

Keith: And those were the early days. When I was at my former firm, PWL Capital, we were using exchange-traded funds exclusively to build portfolios.

Ruben: Oh, nice.

Keith: And so fast forward 20 years, we’ve been using exchange-traded funds. I don’t think the Canadian story is as successful as around the world in terms of Canadians being open and embracing it. Talk to us about where the numbers are at right now, Ruben.

Ruben: Yeah, exactly. So when we are talking about exchange-traded funds, which is an investment vehicle, we can compare it with mutual funds. And most people will be familiar with mutual funds. Right now, the mutual funds industry in Canada, in terms of asset under management, it is at 1.6 trillion. And when you think about exchange-traded funds, even if they are lower fees, more efficient, they are at 236 billion. So you can see that the mutual funds industry is way bigger than the ETF, the exchange-traded funds in Canada. And if we talk about expansion, when we compare the ETF, so exchange-traded funds, value asset under management in Canada versus the US, in Canada, like I said, it’s at 236 billion, but in the US, it’s 20 times higher. So it’s at 4.7 trillion.

Keith: Trillion.

Ruben: Sorry, 4.7 trillion. Thanks, Keith. So you can see how ETF was adopted a bit more very quickly, actually, in the US compared to Canada. There’s a slowness in adoption in Canada.

Keith: Yeah, like speaking with a lot of ETF players, they speak to the success and the speed of which Canadians are adopting. I always challenge back and say, listen, we are not adopting anywhere near as fast as we should be adopting. The mutual fund industry is still eight times the size of the ETF industry. There’s some structural issues as to why that’s occurring. And I think first and foremost, Canadian banks never supported an ETF for the first 15 to 18 years. They saw the ETF as a threat. They saw the ETF as a threat to their profit margins. They are only in the last two years now realizing that if they don’t build some of their own ETFs, if they don’t offer some ETFs in their own platforms, they will come across as incredibly conflicted because Canadians are becoming smarter and savvier with time now. So just as of yesterday, TD has launched a whole new series of exchange-traded funds with a planning platform.

Ruben: Yeah, I saw that.

Keith: That’s great. They exited the business a whole bunch. They were in the business, they got out of the business, they’re back in the business.

Ruben: That’s where the trend is going. I guess they are for-profit companies and they don’t want to miss the boat. And they see that people are becoming more aware, even if there’s still a lot to do, people are becoming more aware. There’s so much information online that people get to know about ETFs. And when you look at the actual flows, that more and more money is going into ETFs. So they want to launch products so that they don’t miss the boat.

Keith: Yeah, absolutely. And one of the other big reasons why we’re not seeing it grow quite as fast as the US is that mutual fund advisors licensed through the MFDA. So this would be somebody who’s licensed to sell mutual funds only does not have the license to sell a security. An exchange-traded fund is considered a security.

Ruben: Because it is traded on the stock market, right?

Keith: It’s traded on the stock market, correct. There’s a lot of amazing financial planners out there that are offering retirement planning, tax services, insurance, and risk solutions. But unfortunately, they don’t have an opportunity to charge a fee and then use exchange-traded funds. The systems are a little bit archaic in this country. That said, I suspect that exchange-traded funds and indexing, they’re on the cusp of booming in Canada because you cannot speak to anybody within the investment community anyway who is now not aware of them and who doesn’t realize that these are really amazing vehicles to be using with clients. So it is now only a matter of time before we really pick up and the revolution becomes full steam ahead in Canada.

Ruben: So Keith, what you’re saying is that there are many reasons why the adoption of exchange-traded funds and other related index investing has been slow in Canada. But what’s good now, what’s amazing is that we are at a tipping point right now. More and more Canadian investors are becoming aware of ETFs and index investing. And they are actually adopting it because when you look at the flows, when you look at where the money is going in terms of investment and you compare exchange-traded funds and mutual funds, there’s more and more going to exchange-traded funds in comparison to mutual funds.

Keith: Absolutely. You know what, you’re 100% correct. And if I go back in time when we wrote, let’s say, the Empowered Investor version one in 2003-2004, there were maybe, I’m going to say, a dozen voices in Canada, advisors really speaking about the benefit of using indexing inside of Canadian portfolios for investors. Now we’re into the hundreds, if not thousands, of advisors in this country, and investors are becoming more aware. There’s more books. There’s more podcasters. Every day you pick up the newspaper, you see the benefits. The journalists are writing about it. So you’re right. We’ve hit the tipping point and it’s going to continue to grow and investors want that and they’re savvy now. They want to push forward. So kudos to the listeners out there that are doing this and congratulations again to all of our clients that are doing this.

Ruben: Exactly. Yeah.

Keith: So Ruben, what’s your takeaway? Let’s wrap the show up on the history and the revolution of indexing.

Ruben: Yeah. So I think as a summary, as we just discussed, index investing and ETF was one of the greatest inventions in the world of finance in the 20th century. So I would say to the listeners, if they have not heard about it, they need to know that the world is embracing ETF and index-based investments. So there’s so many, like you just mentioned, Keith, there’s so many free resources online, blogs, and articles. So I invite them to go and consult and get to know about ETFs and speak to their advisor and see if they can improve their portfolio by using this type of index investing products.

Keith: Beautiful. I love it, Ruben. The only thing I would add is when people think about indexing, because they’re hearing about it now, they may not have heard about it. This is not a five or 10-year fad. And the point of this article or this podcast was to really walk down the 50 years of history of indexing because it is an amazing history. And with that, we’ll wrap up. Thank you so much, everybody, for tuning in to the Empowered Investor. And we look forward to seeing you in two weeks.

Ruben: Thank you to all.

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