Philadelphia Reflections

The musings of a physician who has served the community for over six decades

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Passive Investing With Total-Market Index Funds

What we once called investing in the stock market, is now increasingly called "active investing" because of one man, John Bogle. Mr. Bogle, a main-line Philadelphian, invented index investing (now renamed "passive" investing) as a competitor to "stock-picking", now to be called "active" investing. It's made possible by high-speed computers.

The original index investing used the Standard and Poor 500 list, providing high-quality diversification, adjusted for size. It was probably selected because it had a good record of smoothing out three common variables in a stock portfolio. Other lists had good records, too, but generally the stock-pickers for the list were famous and therefore well-paid, hired by successful companies which took another cut for selecting such good stock-pickers and advertising their success. This arrangement selected stocks which performed well, but it added a cost. When computers made it possible to construct an index of the entire stock market of a nation, or even the whole world, it emerged that such inclusive lists performed as well or even better than active stock-picking, net of transaction costs. Because the index changed slowly, transaction costs were fewer, and consequently taxes were lower. Indices were then tested for different nations, different industries, different sizes, or any other sort of difference. While many claims have been made for particular semi-active indices, they all increase internal trading volumes, so their costs also go up. At the moment, it is generally felt that results are very similar; it is certainly true that trillions and trillions of dollars are shifting from active investing to passive index-investing. Nation-wide, or even world-wide, indices are thought to be essentially investments in the economies of the whole geographic area. The ultimate simplicity would be to buy the certificate, put it in a bank lock-box, and forget it for a lifetime. So far, this is essentially how things have worked out.

In spite of the stampede-like character of recent trading, there is still a majority of stock in individual accounts. Most of this stock has accumulated taxable gains which would diminish in net value if sold, and simple inertia is also not to be under-estimated. If all such stock were converted to passive accounts, no one can say if the net result would raise or lower the final value of index holdings. Nor can you be sure the unsold hold-outs would be largely limited to insiders who have personal agendas rather than economic ones, eventually leading to unfortunate gyrations of the aggregate price which would lessen ties to true value. Nor can anyone say whether the habit of buy-and-hold will become so ingrained that people will hold on when they should be selling. All that might be said is that, so far, none of this has made an appearance. And meanwhile the sands of time are running out, the train is leaving the station. At present, the most likely prediction is that overall volatility will be reduced, but true value can be assessed by the P/E ratio, the ratio of price to earnings. And a lot of brokers will have diminished income.

At the rate things are going, answers to this sort of question will seem stable in about five years. Beyond that time, waiting for more answers will probably mean waiting forever. So let's ask the simple question again. Why not use some sort of a total stock index as a replacement for gold in the return to a gold standard? Forget about going beyond national control toward individual citizen control, because that answer is already predictable: traders will like it, governments won't.


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