Wells Fargo and Indexing

Early proponents of indexing were Wells Fargo, American National Bank and Batterymarch. Each had a slight variation that was designed to be superior; each had a booster or two from academia and each garnered a small percentage of some of the large pension funds in the United States. Curiously, university endowment funds, run by successful alumni, not faculty, were not among the early entrants.

Timing of the acceptance of indexing was critical. Following the nearly 50% US market decline in 19734, new ideas which might have been rejected just a few years earlier were sought. Ideas that challenged convention were readily accepted since conventional ideas had just demonstrated they could be costly in a decline. Each market phase brings forth its selection of new strategies to support hope and expectations. Indexing was right for the time and the time was right for indexing.

Wells Fargo endorsed investment in the full S&P 500 stock index with only a handful of de-selectees for prudence (reputedly, these handily outperformed even a risk-adjusted measure). American National had a sophisticated sampling technique to reduce transaction costs, a likely source of underperformance. And Batterymarch, thinking that index investors would ignore month to month wiggles of sampling error that would cancel in time, just bought the largest 250 stocks, which were 90% of the total. Batterymarch also tried, and failed, to promote the notion that low cost mechanical replication of any index, not just the S&P, was the goal.

Early clients were happy with the results, which kept pace with active managers even when small stocks pulled ahead in the new, quantitatively-driven market then just beginning. And more money came into the strategy in the billions. Meanwhile, the debates between passive managers, as the indexers were called in error

What is Indexing?

Indexing is an investment practice that aims to match the returns of a specified market benchmark. An indexing manager or tracker attempts to replicate the target index by holding all or, with very large indexes, a representative sample of the securities in the index. Traditional active management is avoided with no investments made in individual stocks or industry sectors in an effort to beat the index. The indexing approach is often described as passive, emphasizing broad diversification, low trading activity and low costs.

Indexing as an investment practice has won acceptability in the last two decades as the mechanical outgrowth of a body of academic insights about markets and managers. Indeed, it was one of the first ideas to be propounded by finance academics from their empirical studies. These pointed out that the average manager would produce sub-average results due to expenses and above average managers would be identified and given more assets until they too became less than average. The system was the trap. After all, index accounts have prices set by all managers. In a sense, these accounts are the most managed of portfolios.

Indexing seems dull. Stock selection is done by a nameless committee at Standard & Poor's (S&P) or elsewhere for other indexes. Proportions are set by market prices, which are the aggregate wisdom of all participants. And administration is relatively simple because transactions are bunched together at the very instant at month end when the index composition may be rearranged.

In the late stages of the one-decision bull market of the 1960s, the idea of mechanically investing in the average just because it was the average would have failed. But in the mid-1970s, when a sharp market correction slayed the old gods and raised up new ones, it was just the thing. Nothing could challenge a roster of active, aggressive managers better than to have a mechanical bunny running the performance race with them and the bunny did not require dog food.

The Future of Hedge Funds

Hedge funds and their appetite for risk continue to appeal to investors, perhaps reflecting the late stages of a bull market, where attitudes to risk shift in two complementary ways: the future appears less risky; and, at the same time, investors' appetite for risk rises. But their bad experiences in 1998, the possibility of worse in the future, and the potential regulatory backlash suggest that their fashionable status as high-end mutual funds may wane.

But one hedge fund manager definitely worth continuing to be aware of is James Cramer of Cramer, Berkowitz & Co., who is also co-founder, co-chairman and contributing editor of TheStreet.com, an online financial publication self-described as "dedicated to providing investors with timely, insightful, and irreverent reporting and bringing accountability to the markets and the media that cover them." This is one of the most entertaining investment sites on the internet.