The Index Fund – the Combine Harvester of Investments

The combine harvester is one of the most important innovations in modern economic history. This is how Wikipedia describes it:

The modern combine harvester, or simply combine, is a versatile machine designed to efficiently harvest a variety of grain crops. The name derives from its combining three separate harvesting operations – reaping, threshing, and winnowing – into a single process. Combine harvesters are one of the most economically important labour saving inventions, significantly reducing the fraction of the population that must be engaged in agriculture.

By hand, threshing alone used to be one of the most laborious and time-consuming tasks in agriculture, with a single bushel of wheat taking an hour. By contrast, the best combine harvesters can reap, thresh and winnow nearly 5,000 bushels an hour.

Can you imagine what the UK would look like now if farmers still had to do these things manually? In 1841, it required 22% of the workforce to produce the food the nation needed. These days, it requires less than 1%. That means nearly 7 million people are freed up to produce the goods and provide services that make our standard of living, in 2017, something our ancestors in 1841 would have found difficult to imagine.

So what does agriculture have to do with index funds? Well, like the combine harvester, the index fund is one of the most important innovations in its “field” (excuse the pun).

Index funds efficiently “harvest” practically all of the returns of equity and bond markets, thanks to their miniscule costs and very low portfolio turnover. They are the most important labour and cost saving innovation in the history of investment management.

Unfortunately, they haven’t been anywhere near as widely used as they should have been in the 40 years since they came into existence. It’s far more lucrative for fund management and financial advice businesses to do things the old way, with active management. If only it were so lucrative for their clients. While the owners of fund management companies have enjoyed market-beating returns for decades, investors in the funds themselves have, in aggregate, woefully underperformed the total market returns that are available with index funds.

 

In 1737 Andrew Rodger, a farmer on the estate of Cavers in Roxburghshire, developed a winnowing machine for corn, called a ‘Fanner’. These were successful and the family sold them throughout Scotland for many years. Some Scottish Presbyterian ministers saw the fanners as sins against God, for wind was a thing specially made by Him and an artificial wind was a daring and impious attempt to usurp what belonged to God alone.

When Jack Bogle first launched the index fund, many on Wall Street called it “un-American” – a sin against capitalism, if you will. Those who benefited greatly from the high fees generated by active management naturally wanted to preserve the status quo (turkeys are not in the habit of voting for Christmas).

In fact, the index fund represents competition and capitalism at its best. Jack Bogle’s Vanguard and its funds, as well as all the copycat index funds that came after, have saved millions of people many billions of dollars, euros and pounds. That’s why Warren Buffett, the world’s most famous investor, said at the 2017 Berkshire Hathaway shareholder’s meeting that Bogle has done more for American savers than anyone else in history.

You may (or may not) be surprised to learn that the take up of index funds by UK financial advice firms has been miniscule, despite them having been available for over 30 years. Most advisers prefer using the “scythes” of old – costly actively-managed funds. Unfortunately for their clients, the majority those funds have done the equivalent of taking a scythe to their long-term returns, often cutting them in half or worse.

The good news is that more and more evidence-based investment advisers are doing the right thing for their clients and putting their money in index funds. 40 years after the 1976 launch of Vanguard, last year its funds took in more money than the rest of the global fund industry combined.

As for those who continue to use costly active funds – whether they realise it yet, or not, the Grim Reaper is coming for their business models. Perhaps Berkshire Hathaway vice-Chairman Charlie Munger put it best in early 2017: “The index thing is absolute agony for investment professionals … who have almost no chance of beating it,” Munger said. “Most people handle that with denial … I understand — I don’t want to think about my own death, either.”

Phil Miller – Head of Client Services, Marland Thomas
28 November 2017

The information in this article is necessarily of a general nature. It does not represent either legal advice or financial advice. Specific advice should be sought for specific situations.