Mr. Wheeler clearly thinks we should have seen it coming. Investors flocked to index funds in the late 1990s, driving pricing and multiples skyward. At the peak of the market, the largest 50 stocks had price-to-earnings to growth ratios more than 60% higher than those of the Russell Midcap index, he noted. And active managers did no better, keeping within a short distance of the benchmark, he added.
"People talk about an Internet bubble, but institutions have foisted upon themselves a massive big bubble," he said in the interview.
Looking at the situation in other terms, Mr. Wheeler said if the Russell 3000 index had increased by 20% to 50% instead of fallen, the stock market's capitalization would have soared another $2 trillion to $7 trillion — instead of falling by $2 trillion.
That difference — what Mr. Wheeler wryly refers to as a $6 trillion "rounding error" — represents seven months of gross domestic product for the United States, four years for the United Kingdom, 40 years for Denmark — or 400 years each for Estonia, Botswana, Guinea or Yemen, he told Q-Group members.
Mr. Wheeler said institutional investors might be stuck in an old paradigm. Citing Thomas Kuhn's 1962 "The Structure of Scientific Revolutions," Mr. Wheeler explained that scientific progress does not occur in a steady path, but more typically has dramatic changes — or "paradigm shifts" — when thinking is revolutionized.
Usually, a small community of scientists are engaged in cutting-edge thinking in their given area. But it takes someone from outside this informal "college" to shake things up by introducing a new paradigm, Mr. Wheeler said.
"Robert Dalton was a Scottish meteorologist who discovered atomic weights and revolutionized chemistry. Einstein was a Swiss patent clerk. Ben Franklin had many interests," Mr. Wheeler told the Q-Group. And Messrs. Markowitz and Sharpe were graduate students, not financial-services professionals, he added.
It took time, but eventually MPT — and its offshoot, the Capital Asset Pricing Model — took hold in academic finance, and then in practice, with the development of index funds.
Reliance on MPT
The problem is that the market relies too heavily on the MPT paradigm, Mr. Wheeler said. Measures such as market cap, book-to-market and beta — a measure of a stock's riskiness relative to the entire market — dominate the industry.
Virtually ignored is another relationship central to capital markets, he said. The missing variable: price is a function of forecast earnings.
"Beta, cap and other style factors do not drive outcomes as much as getting the earnings right, and betting when the consensus disagrees," Mr. Wheeler told the Q-Group. "Perish the thought, I sound like a fundamental investor who has read too much (John Maynard) Keynes."
After making a pitch for value investing, Mr. Wheeler returned to the flaws of investing in market-cap-weighted indexes.
"The common-sense trap in indexing is that it makes the most sense if you are the only one to do it, leaving everyone else to diligently perform price discovery. Once someone else does it, price discovery begins to dilute. When a lot of people do it, and when their numbers increase rapidly, you create the megacap bubble that existed at the end of the 1990s," he told the Q-Group.
Robert Arnott, chairman and chief executive of Research Affiliates LLC, Pasadena, Calif., agreed that "mainstream indexes are very flawed representations of how the broad market is performing." He predicted the industry will adopt "a wider array of indexes — cap-weighted and non-cap-weighted." Mr. Arnott is developing his own index that does not rely on capitalization weights.