Jim Wiandt

Passive Investing Trends:

Index funds are on the rise. Assets flowing into index mutual funds have been rapidly growing both in absolute terms and relative to inflows into actively-managed funds. The million-dollar question is whether these inflows have resulted from investors seeing the light and investing in the passive funds on merit, or simply chasing returns? Only recently has the body of data become sufficient to properly analyze the question. Given the implicit cautiousness of index funds, it is both ironic and telling that index funds have boomed relative to active funds during the roll-out-the-barrels bull market of recent years.

So what is ironic, and how is it telling? The ironic part is that ostensibly one would think that a penny-pinching index strategy that forgoes any bet and plays every number on the roulette wheel for even money at minimum cost would appeal in down markets when every basis point counts. Telling is the fact that return-chasing money moved into index funds. Why did it move? By and large index fund returns throttle the active competition, particularly in bull markets. When the market is steaming ahead, every dollar not invested in the market by a fund is a cash drag against returns. That, coupled with the ever-present reality that transaction and management costs go up with, well, the additional transactions and management required by active management, led to significant outperformance of active funds by the market, as represented by the Wilshire 5000 as you'll see later in this article.

The data seems to indicate that this is what has driven the indexing boom. Quite simply, over the time period of 1990-2000, inflows into mutual fund generally reached their highest levels, both in absolute terms and relative to total mutual fund inflows, when the markets were doing best. The chart and table below below examine Financial Research Corporation (FRC) and Investment Company Institute (ICI) data and present index fund inflow data both in absolute terms and as a percentage of total.

The Big Picture

While the first retail index mutual fund, the Vanguard 500, was launched in 1976, according to Financial Research Corporation data, inflows into index funds only topped $1 billion in 1989. Of course the trickle soon became a deluge, though, and by April of 2000, right in the vicinity of both the broad stock market and technology sector's nexis, the Vanguard 500 assumed the mantle of largest mutual fund by capitalization. Why? Framed in that way, the question seems to answer itself - assets peak just as returns peak.

A number of issues bear examination, however. How have relative inflows looked in up and down markets? When have inflows been hit the hardest relative to total mutual fund inflows? Here, of course is where we find our Occam's Razor. When are index fund inflows at their highest level relative to all funds and why? When is their fall in inflow relative to all funds greatest and again why? For purposes of our analysis, and in the previous table, we examine the 10-year time period of 1991 - 2001. Using Investment Company Institute (ICI) data for the total universe and FRC data to examine index fund inflows we can examine the facts:

• The all-time high for inflows into index funds, domestic equity funds, and the Vanguard 500 in absolute and relative terms occurred in the first quarter of 1999 - the last year of the freight train bull market that steamed through the five years from 1995-1999.
• In 2000, the first losing year for the S&P 500 since 1990, equity index inflows fell 63% off the record year, amounting to just 7% of equity mutual fund inflows (down from 29% in 1999). This abysmal trend continued into the first quarter of 2001 with active managers, finally getting a chance to harvest the fruits of a merciful bear market, banging the drums. Q1 index fund inflows were at their lowest level since Q3 1995, when the magical run got underway.
• Pre-bull, the data is somewhat less conclusive. In fact, though index inflows more than doubled from 1990, when the market was down, to 1991 when it returned over 30%, index fund inflows as a percentage of total fund inflow actually decreased, from 4.5% to 3.9%.
• In a middling market, that percentage continued to decline nominally until it reached 3.4% of the total in 1993. In the faltering market of 1994, index fund inflow increased to 5% of the total inflows fell by more than 50%. More telling though, is the fact that in the weaker 1990-1994 market, equity index inflows fell steadily from 14.0%, 9.9%, 6.8%, 5.4% to 3.4% in the down market of 1994.
• Welcome 1995: equity index fund inflows parallel the rocketing market, amounting to 8.3%, 10.5%, 13.5%, 24.2% and 29% of equity inflows from 1995-1999.

The Ultimate Oranges to Oranges Comparison

In terms of the sheer amount of inflow and returns data available, there is no better comparison to examine than the Vanguard 500 (the oldest retail index fund) and the S&P 500. Using FRC inflow data for the Vanguard 500 fund and Ibbotson Yearbook data for S&P 500 annual returns and 5-year trailing returns we can examine 15 years of inflow and returns data for a single index/ index fund.