Acquired
01:13:04 · Ben Gilbert, David Rosenthal
[01:13:04] S0: us to 1974 and the journal article that inspired it all. [01:13:09] S1: Yes. Yes. The Journal of Portfolio Management, where Nobel Prize winning American economist Paul Samuelson had written that fall in 1974 that he had been studying market returns and active fund manager returns in this new mutual fund industry, and he had found no actual evidence that any fund managers could systematically outperform the market. And in the conclusion of the paper, he argues that, well, there's an obvious, opportunity here. Somebody should come along and offer a fund that, quote, apes the whole market, requires no load, and keeps commissions, turnover, and management fees to the feasible minimum, AKA an index fund. [01:14:06] S0: And interestingly, I actually didn't realize he proposed the sort of commercial availability of it like that. The part of it that I read was some large foundation should set up an in house portfolio that tracks the S and P 500 index if only for the purposes of setting up a naive model against which their in house gunslingers can measure their prowess. Yeah. No. He was thinking about distribution to retail, like, in that paper by talking about no load, but you are touching on something. This idea of an index fund that would passively track the stock market was not totally new. A couple people in institutional circles
01:14:06 · Ben Gilbert, David Rosenthal
[01:14:06] S0: And interestingly, I actually didn't realize he proposed the sort of commercial availability of it like that. The part of it that I read was some large foundation should set up an in house portfolio that tracks the S and P 500 index if only for the purposes of setting up a naive model against which their in house gunslingers can measure their prowess. Yeah. No. He was thinking about distribution to retail, like, in that paper by talking about no load, but you are touching on something. This idea of an index fund that would passively track the stock market was not totally new. A couple people in institutional circles [01:14:49] S1: had had the same or similar realization in the years leading up to this, that this could be an interesting idea. And in fact, the whole idea of having an index or indices in the first place really is the precursor to this idea. Like, people wanted some way to measure the entire market. I mean, that's what the Standard and Poor's 500 is. That's what the Dow Jones Industrial Average is. These things go all the way back to the eighteen hundreds. Like, newspapers wanted a way to report on the movement of the market. [01:15:21] S0: The delicious thing is that it took, like, a hundred years from the founding of those to think, maybe this isn't just a benchmark we should measure ourselves against, but maybe this is actually a great investment product. [01:15:33] S1: Yes. This could be an asset class in and of itself.
01:15:33 · David Rosenthal, Ben Gilbert
[01:15:33] S1: Yes. This could be an asset class in and of itself. [01:15:36] S0: And it makes sense because why would anyone want to buy the average? I mean, why would you want to own the fiftieth percentile of the market isn't the whole point to work with a great investment manager who can beat the market. Why would you just want beta? You want alpha on top of beta. It's not a immediately saleable proposition to say, hey. Don't you wanna be average? [01:16:01] S1: Right. Right. It's uniquely counter to this sort of whole American way of being and aspiration of America. American exceptionalism. It's funny. If this had all been in Europe or somewhere else, it might have emerged sooner. [01:16:15] S0: But That's [01:16:15] S1: funny. Anyway, so, yeah, a couple people had tried to make this idea work on the institutional side before. Most prominently, the pension management division of Wells Fargo, so, like, the division of Wells Fargo that would manage and administer pensions for large corporations. They had actually created an index fund for the pension fund of the Samsonite Luggage Corporation a few years earlier. Amazing. Incredible. But it had failed. They couldn't make it work because, actually, this was a deceptively hard problem. In order to do this, to create a fund that continuously tracked something like the S and P 500 index, you needed a lot of software. You had to have automation. Humans could not do this.
01:16:15 · David Rosenthal, Ben Gilbert
[01:16:15] S1: funny. Anyway, so, yeah, a couple people had tried to make this idea work on the institutional side before. Most prominently, the pension management division of Wells Fargo, so, like, the division of Wells Fargo that would manage and administer pensions for large corporations. They had actually created an index fund for the pension fund of the Samsonite Luggage Corporation a few years earlier. Amazing. Incredible. But it had failed. They couldn't make it work because, actually, this was a deceptively hard problem. In order to do this, to create a fund that continuously tracked something like the S and P 500 index, you needed a lot of software. You had to have automation. Humans could not do this. [01:17:10] S0: Right. The point of the S and P 500 is to create a subset of the total market that has essentially the same returns but with a smaller set of companies. So you don't need the thousands of companies. You just need this 500. But even setting up the systems to track 500 companies' movements day to day, sophisticated. Yeah. The other thing that makes it challenging is it's kind of expensive to buy, especially in whole share denominated amounts, a representative correctly weighted set of the entire S and P 500. Today, the minimum quantity of dollars you would need to do it on your own without buying into a fund is about 3 and a half million dollars to the sort of minimum efficient or or minimum representative S and P 500.
01:17:10 · Ben Gilbert, David Rosenthal
[01:17:10] S0: Right. The point of the S and P 500 is to create a subset of the total market that has essentially the same returns but with a smaller set of companies. So you don't need the thousands of companies. You just need this 500. But even setting up the systems to track 500 companies' movements day to day, sophisticated. Yeah. The other thing that makes it challenging is it's kind of expensive to buy, especially in whole share denominated amounts, a representative correctly weighted set of the entire S and P 500. Today, the minimum quantity of dollars you would need to do it on your own without buying into a fund is about 3 and a half million dollars to the sort of minimum efficient or or minimum representative S and P 500. [01:17:57] S1: So couple years after this, along come Jack and Vanguard in this unique moment where they they need something to make their model work, and computing and software is, like, just now starting to be capable of handling this. [01:18:14] S0: And Jack is reading the docs very carefully. He's having tight communication with his board of directors, and he realizes he's got a little bit of daylight here. [01:18:25] S1: He's got a loophole. [01:18:26] S0: Yep. Where he can say, I am not actively taking Vanguard and having it offer investment advice in any way here. But what we do wanna do is we wanna create this new fund that will require no investment advisory services, that will purely be this index of the S and P 500, and we can run it under Vanguard, and it's within our mandate. [01:18:50] S1: Yeah. We don't need to involve Wellington.
01:18:50 · David Rosenthal, Ben Gilbert
[01:18:50] S1: Yeah. We don't need to involve Wellington. [01:18:52] S0: His board agrees. Yeah. This is sort of the acid test. He goes, and this is what do you think? Is this what you've given me permission for? And they come back and say, yes. [01:18:59] S1: Yes. As Jack puts it in his memoir, you know, kinda like, you know, rendering a guilty verdict in a legal trial, He and early vanguard there had both the opportunity to commit the crime or, in this case, you know, create the first index fund, but also the motivation to do so because this was the way around this prohibition against active management. [01:19:22] S0: And the thing that Jack was starting to realize, which is the culmination of his senior thesis and the Paul Samuelson article, is that this could actually be very successful. [01:19:32] S1: Yep. [01:19:32] S0: He runs the numbers because he's Jack. The S and P index without the fees beat half the active managers. And over the full decade, it would beat 78% of them. So Jack realized, wait a minute. It's impossible to run an index at zero cost. But at scale, actually, you could approach zero cost. If you just own the S and P, then you could beat three quarters of the other mutual funds in the market. So there really could be something here.