After a rocky start, indexing gains a foothold among pension funds as a legitimate option for managing money.
Index funds had their genesis in the mid-'60s in Eugene Fama's efficient market hypothesis. But probably the first effort to implement the concept occurred in 1969, when William Fouse tried to persuade Mellon Bank in Pittsburgh to start a fund that would track the market. The idea was rejected.
When a second suggestion -- that of applying a dividend discount approach to investing -- also was rejected, with the words: "Damn it Fouse, you're trying to turn my business into a science," Mr. Fouse joined the management sciences department at Wells Fargo Bank.
When he arrived, the department was in early discussions with Samsonite Corp., which was interested in a new approach for its pension fund. The management sciences team came up with an index fund based on the equally weighted New York Stock Exchange index -- the very first index fund. It proved a nightmare to manage. Keeping the portfolio equal-weighted in line with the index as some stocks moved up and others declined in value required heavy trading, and thus the fund incurred high trading costs, particularly in that era of fixed commissions.
Next Wells Fargo developed the Stagecoach Fund, a portfolio of low-beta stocks leveraged up so the beta of the portfolio was 1.0. The fund was set up as a closed-end mutual fund to be marketed to pension funds and other institutions. After almost two years of marketing, only $30 million had been committed, so the fund was dropped in November 1973.
The idea of index funds caught on among a few money managers in the early '70s. Wells Fargo, American National Bank & Trust, Batterymarch Financial and American Express Asset Management were the first to offer such investments to pension funds.
FIRST PUBLIC MARKETING
In September 1973, American National Bank and Trust Co. of Chicago began running a $20 million market index fund tied directly to the Standard & Poor's 500 index -- probably the first publicly marketed S&P 500 index fund. The bank converted a commingled fund into the index fund from an active approach, and received no objections from clients. The index fund bought all of the securities in the S&P 500 in the same weighting they were in the index. As a result, its performance almost exactly matched the performance of the index, which at that time most closely represented the performance of the stocks invested in by active money managers.
At a time when active managers in general were down more than the index, this strategy had the potential to attract a lot of business.
The idea for the American National index fund had come from Rex Sinquefield, a young MBA from the University of Chicago who had been hired by the bank in January 1972.
Mr. Sinquefield had been turned on to modern portfolio theory at the University of Chicago, where his professors included Merton Miller, Eugene Fama, Roger Ibbotson and Fischer Black.
"The first time I heard the notion of market efficiency I thought it had to be true," Mr. Sinquefield said.
He became interested in the investment business and after he graduated he wanted to apply all of the new ideas. He applied to all of the trust banks in Chicago, but was turned down by all except American National Bank and Trust.
About six months after he started at American National, Sinquefield wrote a memo proposing the bank start an index fund, which he called an "S&P market fund." He received no reply, but pursued the issue anyway.
A number of objections were raised. At the time, brokerage commissions were fixed, so large trades could be expensive and trading costs were an issue. In addition, there was no Depository Trust Co., so all transactions involved the transfer of paper certificates from one institution to another.
Tom Ransome, vice president in charge of the investment division of the trust department, favored the index fund idea and pushed it through top management at American National, allowing the conversion of a commingled equity fund to indexing. None of the clients in the commingled fund objected.
However, this was just a start. The fund had to be marketed to larger clients, the same problem faced by Wells Fargo and Batterymarch.
American National's first index fund client, other than the commingled fund, was the $1 billion New York Telephone pension fund overseen by Robert Shultz.
Mr. Shultz, like George Williams at Illinois Bell, was eager to try something new. He was intrigued by modern portfolio theory, and he began to examine the index fund idea. After long interviews with American National, Mr. Shultz recommended the concept to the New York Telephone investment committee.
Batterymarch Financial Management in Boston had introduced its own indexed strategy about a year after Wells introduced its Stagecoach Fund, and by November 1973 still had found no customers. Rather than abandoning the concept, Batterymarch lowered the fee for the fund to $25,000 from $100,000 for a $100 million account.
Batterymarch's index fund took a different approach. The firm planned to buy the 250 largest stocks in the S&P 500 in the same weighting they were in the index, giving the fund a beta very close to 1.0. Founder Dean LeBaron's idea was that the largest 250 stocks accounted for more than 90% of the value of the stocks in the S&P 500, and therefore accounted for more than 90% of the movement of the index. Buying only the 250 largest and most liquid stocks would keep transactions costs down. Also, each indexed client would have its own separate index fund because Batterymarch could not legally pool its clients' assets.
Batterymarch's index fund was not to get its first client for a year.
By mid-1975, American National had declared indexing to be its primary approach to investing. Henceforth, only about 10% of a typical account would seek to outperform the market, while 90% of the account's assets would earn at least the market return.
The index fund concept initially was received with derision, and even hostility by active managers, brokerage firms, many pension executives and the occasional academic.
Critics accused those pension executives who invested money in index funds of "settling for mediocrity."
Others declared indexing was "un-American" because no effort was made to try to select good companies over poor ones. The index fund bought all companies in the index, good performing ones and bad, except for those on the verge of bankruptcy.
And, the validity of the index fund concept vs. active investment management was a topic of hot discussion at many pension fund conferences.
The debate raged in the pages of Pensions & Investments during 1976, with respected academic and practitioner Roger Murray, a professor of finance at Columbia University's Graduate School of Business, writing that index funds were an idea whose time had passed. Mr. Murray provided five reasons index funds were not a good way to manage assets, the key one being that it involved "looking ahead through the rear-view mirror."
In the same issue, Townsend Brown, a vice president and director at Wood, Struthers & Winthrop Inc., New York, argued indexing was a "cop-out," that indexing would be too expensive, and that these "trendy" funds would go the way of the Edsel.
Rex Sinquefield and Bill Fouse each responded, noting numerous studies had shown professional money managers as a group were unable to equal, let alone outperform, the market consistently.
Mr. Fouse argued the index fund should be the foundation of equity management, as it allowed diversification and flexibility. He also proposed the index fund could be a repository for the stocks active managers did not want to hold, and a source for those they wanted to buy.
Over the next few years the index funds outperformed more than half of the active managers consistently, except for the late '70s, when small-cap stocks were outperforming all others. Several additional studies in the '70s supported Mr. Sinquefield's position that active managers could not consistently beat the index. The key word was consistently. Individual managers could beat the index for a few years, but very few could beat it consistently over a long period.
As a result, many funds, especially large funds, began to consider index funds for at least part of their assets.
Despite the protests of Messrs. Murray and Brown, and scores, if not hundreds of active money managers, the growth of index funds could not be stopped.
Bankers Trust Co., the second-largest manager of pension assets, became a convert when it announced in September 1976 that it would offer an index fund to pension clients, although it intended to continue to offer active management also. Bankers Trust, at the time, managed $15 billion of pension assets.
By the end of 1976, index fund managers were reporting a total of $1.7 billion in indexed assets, a remarkable growth rate in less than three years.
The great bulk of these assets was in the hands of American National Bank and Wells Fargo Investment Advisors, each of which managed $500 million; and Batterymarch, which managed $375 million.
The use of multiple managers by pension funds was behind another experimental innovation, the inventory index fund.
The idea behind this was to cut transaction costs at large funds by eliminating duplicative trading by the managers. Some large funds had noticed that soon after one manager sold, say, $10 million worth of IBM shares, another of the fund's managers might buy a similar amount of IBM. Both managers incurred significant brokerage fees, and in addition, each might have adversely affected the price of IBM stock by their trading activities.
If, however, there were an inventory fund to which managers could sell stock they no longer wanted, and from which they could buy stock they did want, transaction fees could be saved.
An index fund was the perfect vehicle to house the inventory. The index fund would be rebalanced once a month to bring its holdings and weightings in line with the chosen index. The monthly trading minimized transaction costs.
The only danger was that the performance of the fund would differ significantly from that of the index because the weightings would be thrown off by the trading in and out. But that performance difference was as likely to be positive as negative.
Glenn Kent, the creative manager of investments for Honeywell Inc.'s $270 million pension fund, established the first inventory index fund in July 1977. The index fund was run at American National Bank in Chicago. The $1.4 billion General Telephone & Electronics pension fund started running an inventory fund in September 1977, using an index fund overseen by its master trustee, Bankers Trust.
A year later there were six inventory funds in existence. By that time, Mr. Kent estimated, Honeywell's inventory fund had saved an estimated $2.3 million in transactions costs. GTE executives estimated their inventory fund had saved $1 million in transactions costs in its first year of existence, and the fund was able to accommodate 34% of the trading by the pension fund's managers.
By July 1980 total indexed assets had climbed to $9 billion, and were still growing.
But pioneer Mr. LeBaron told Batterymarch Financial Management clients his firm no longer would offer index fund management.
Mr. LeBaron told clients late in 1981 his firm was abandoning indexing because it was not being used the way he felt it should be -- that is, with 75% to 80% of each fund's assets indexed -- and because the index then in use, the S&P 500 index, was flawed. Twice in the previous 10 years, he said, "half of the index acted like a single stock."
"Last year the S&P 500 was up 32% because of energy. The whole market wasn't up that much."
Competitors scoffed that Mr. LeBaron had abandoned indexing because his method of investing in only the 250 largest stocks in the index was not working well. His index fund had often failed to track the index closely.
In November 1982, Wells Fargo Investment Advisors, another of the indexing pioneers, made the opposite decision: It dropped active management. Wells decided to concentrate on offering its clients a range of equity index funds. At the time, the firm had $6.5 billion of assets under management, but only about $800 million was actively managed.
Wells executives were convinced their indexed funds would outperform the median active money manager over any 10-year period. William Jahnke, head of Wells Fargo Investment Advisors, said: "If the index fund itself is at the 25th percentile over any decade, and there is lack of consistency decade-to-decade among managers, then after two decades the index fund could be expected to be in the sixth percentile of money manages before fees. We think that is an important insight for plan sponsors who are long-term investors."
The move to indexing worked brilliantly. As of Dec. 31, 1981, Wells Fargo Investment Advisors ranked 20th among money managers in terms of pension assets under management, with $6.4 billion. A decade later it ranked second, with assets of $96 billion.
In fact, Wells' timing was impeccable as this was the beginning of a boom period for indexing. By the end of 1985 indexed assets had leaped 70% to $81 billion.
In 1983, Mellon Bank established Mellon Capital Management, a new subsidiary to accommodate Bill Fouse and three other top Wells Fargo Investment Advisors executives, who resigned in a philosophical dispute with the new manager of the division, William Joss.
It was an ironic return to Mellon for Mr. Fouse, who had left Mellon 13 years earlier when the bank refused to back his index fund ideas. Mellon didn't make the same mistake twice, and the move paid off handsomely for the bank. A decade later, Mellon Capital Management was managing $33 billion in tax-exempt assets and ranked 16th among pension fund money managers.
Meanwhile, the departure of Mr. Fouse and key members of his team threatened Wells' reputation and client base. The bank's management kept Patricia Dunn, a senior member of Mr. Fouse's team, and quickly hired Fred Grauer, a former Columbia University Graduate Business School professor and vice president of institutional sales at Merrill Lynch Capital Management Group, as chief investment officer. Wells managed to keep all of its clients, but was still faced with a strong new competitor headed by a high-profile pioneer.
From 1984 through 1987, indexing growth remained strong.
* Early in 1984, the Minnesota State Board of Investment indexed $1.3 billion. The transaction to construct the index fund was carried out by Wilshire Associates, which was to manage the fund indexed to the Wilshire 5000. Only 1,000 stocks were to be bought, but the portfolio was to be constructed in such a way that it mirrored the movements of the whole index.
* Morgan Stanley Asset Management engineered a $1.55 billion switch to indexing for the Central States Teamster fund, hiring both Bankers Trust Co. and Mellon Capital Management.
* IBM announced it was moving 75% of its fund to passive management. It was already almost 50% passively managed.
* The Illinois State Universities' Retirement System more than doubled its passive investments to $1.1 billion of its $2.3 billion assets.
* The $2.7 billion Mississippi Public Employees' Retirement System increased its passive investments to 50% from 20%.