The publication of BURTON MALKIEL’s A Random Walk Down Wall Street in 1973 sparked a growing interest in index investing, and, three years later, Jack Bogle’s Vanguard launched the first retail index fund.
At that time, however, it was very unclear how index investing would develop, or indeed whether it would catch on at all.
In the third and final part of our exclusive interview, analyst JON JACOBS asks Professor Malkiel why, for example, it was Standard and Poor’s and not Dow Jones & Co. that ended up as the primary benchmark provider for US equities.
If you missed the rest of this interview, you can catch up here with the first part and here with the second.
Please note that this transcript has been slightly modified for brevity and clarity.
Jon Jacobs: The question of, “Why did the Dow Jones Industrial Average not become an institutional benchmark?” is very well understood: it was structurally ill-suited for that purpose, comprising just 30 stocks and being price-weighted. But I’ve long wondered why management at Dow Jones & Co. waited until the late 1980s to introduce new, broader stock indices that could have filled the gap.
Burton Malkiel: Yeah, I think it was way too late. But one of the other total stock market indices that Dow Jones got involved with was the Wilshire 5000, and that became the Dow Wilshire 5,000. So I think they got the clue, but it was just far too late. Had they done that at the beginning, I think simply as a business decision… Because this is another whole part of the story that now it’s a business for S&P and they get money by using the index.
From what I can tell, the first index Dow Jones & Co. offered that was broader than the traditional three was started in 1987. It was a total stock market index. That, as I think you agree, was too late for them to really get a hand in the business.
Yeah. I think if they had done this at the beginning…
When would you consider the beginning?
I would think the beginning is about 1976. My first edition of A Random Walk was published in 1973, which recommended indexing. Jack Bogle started the first index fund. It was an IPO in 1976.
I think that’s when they would’ve had to do this. And then there could have been two Dow Jones averages. One that would be used for index funds and for investing, and one that would be the popular Dow 30 that you know, everybody knows. So I think that’s when they would’ve had to have done it. Sometime after the first index fund.
One of the reasons why they might not have thought that this was a great opportunity is, you’ve got to remember that indexing was very slow to take off. You know, Jack Bogle wanted to sell $250 million, but got $11 million. The underwriters said, well, let’s do it as $150 million. It was not a great demand. He sold $11 million and it was very slow to take off.
So you can sort of understand that if you were a Dow Jones executive at that time, and you were recommending that this was a really big opportunity, people would probably have laughed at you.
I think that’s probably one of the reasons why they didn’t do it and were so late to the game.
That’s a good point that the winners like Bogle were people that were early and then they had to put up with the penalties of being early.
Exactly. It was called Bogle’s Folly. And you know, this was thought of as the dumbest idea in the world.
And yet it was so consonant with portfolio theory — the MPT, CAPM and EMH. By 1976, those theories were not only thoroughly accepted in academia, but the CAPM already had a big following on Wall Street. So there must have been a lot of vested interests and egos that weighed in against the indexing idea.
Remember that, to his credit, Jack with Vanguard was not trying to build a really super profitable investment management company. He was trying to provide the best investment outlets for the ordinary investor. And this was a threat to the very large management fees that were being charged by the mutual fund companies. This was a huge threat to what has been an extraordinarily profitable business.
So an index fund or any other low-cost fund would’ve been up against the profit interests of not only all of Wall Street, but also the buy side, the asset management industry.
Absolutely. Yes, I think that’s the conflict. And it’s why you might say, how did Vanguard get these trillions? Didn’t people want to compete with them? If competing with them meant slashing your fees, you think twice about doing that.
So that was another big source of institutional resistance. For Dow Jones, there was also cultural inertia. The Dow Jones management, from a business standpoint, was viewed as hidebound and overly conservative and not really out to commercialise a lot of things. And they saw this as a newspaper company, not a financial data company.
But also culturally in some sense, the whole idea of the Dow Jones Index, which gets reconstituted from time to time, right behind it is the idea of active management.
More than the S&P, for example?
More than the S&P because there are only 30 stocks. So the idea of Google or Alphabet’s now part of the Dow Jones was a big deal because you had just arrived as one of the major companies in the country.
And GE falling out of the Dow Jones as the original, or one of the original members. It used to be the one company that you’d associate with capitalism in the United States.
So I think culturally, the whole idea behind it was this was an index of the most important companies in the country. Typically when something goes into the Dow, it’s a huge company. It’s a Microsoft, it’s a Google or Alphabet. When something goes into the S&P, it’s normally an up and coming company that now has a big enough market value to make a difference in the S&P 500. The rebalancing is from mergers and from much smaller companies graduating to the S&P.
You’re basically saying the S&P 500 rebalancing process is much more disciplined relative to the way the Dow is constituted.
Absolutely. And far less consequential, because the crazy thing about the Dow is, you get split ten for one and all of a sudden your weight in the index has changed.
ABOUT JON JACOBS
Jon Jacobs is an award-winning financial writer who develops thought leadership content for asset managers and other financial institutions. He is currently gathering material for a book about competition among stock index providers.
© The Evidence-Based Investor MMXXIV. All rights reserved. Unauthorised use and/ or duplication of this material without express and written permission is strictly prohibited.