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  • Indexing in America

    Tocqueville told us why it would take root in a democracy.

    Don Phillips, 08/04/2017

    When Jack Bogle launched the first retail index fund in the U.S. market, his creation was labeled “un-American” by critics who believed that independent, profit-seeking American investors would never settle for the surety of an average return. Such notions reek of socialism, they cried. Bogle simply did not understand the American character. More likely, it was the critics who had misread America, or at least misread (or left unread) Democracy in America, the classic analysis of both democracy and the United States, in which Alexis de Tocqueville lays out exactly the reasons why Americans, sooner than any other nation, would prove apt to embrace indexing 150 years later.

    According to Tocqueville, democracy was primarily defined by equality. In America, a free people forged a democratic society based on the notion that “all men were created equal.” Under such beliefs, citizens don’t look to a wise leader for guidance, as is done in aristocracies, but instead trust their own instincts and judgments. So far, that would seem to argue that Americans would seek their own investment path and pick their own stocks, which would presumably lead them away from indexing, hence the critics’ lambasting of Bogle’s “folly” in launching an index fund.

    But Tocqueville’s theory doesn’t stop there. He notes that no one can be an independently forged expert in all subjects. There are many issues on which one must rely on others to master and then take guidance from them. In an aristocracy, people look to those considered the best to be that authority. In a democracy, where people believe all have near equal abilities, it is the majority opinion that holds sway. As all citizens are believed to be equal in America, whatever the most judge to be true is seen as the most likely to be correct. Put another way, if this were Who Wants to Be a Millionaire?, Europeans would phone a friend, Americans would ask the audience.

    What is indexing, after all, but turning one’s back on the aristocratic notion that superior investment talent exists and can be identified and instead opting to participate in the collective wisdom of all the market’s participants? That indexing can be done at lower costs obviously strengthens its case, but that virtue is more linked to the Vanguard narrative than the indexing story. (Vanguard funds are always low cost; index funds have been launched with low and with high costs.)

    If Tocqueville’s read on democracies and aristocracies holds true, we would expect indexing—the choice to mimic the collective actions of the crowd—to take root first in America, then in European nations, which have become democratic, but still have the overhang of aristocracy, and then more slowly to countries with a more recent history of totalitarian regimes. While Tocqueville obviously wasn’t thinking of indexing, the lessons from his insights have borne fruit. Indexing accounts for over 40% of the asset-management market in the United States, 25% in Europe, and far smaller percentages in emerging markets, especially among retail investors.

    Tocqueville believed in the 1800s that the spread of equality was certain to continue, as indeed it has. To the extent that democracy has gained strength, so we should expect the percentage of assets that are indexed to continue to rise globally across all regimes with democratic elements. Indexing may have its roots in America, but its growth, like that of its cousin democracy, will not be contained within one nation’s borders.

    There’s another element that plays into the rise of indexing, much as it did in the rise of democracy, and that’s the education of the people. As people gather experience and information, they make better-informed decisions. This, too, promotes democracy as well as indexing. I recall talking to people at Vanguard in the 1980s, and they related that one of the early audiences for their then-neglected index fund was mathematicians. Those who knew numbers and grasped statistical analysis opted more readily for the path of indexing. We’ve seen the same in broader investment circles where institutions have moved more quickly to passive strategies than have retail investors. As market participants globally grow more informed, we can expect that more of their monies will be invested passively.

    Indexing is not the best way to invest for everyone. Higher gains can be won by those with superior ability and focus. But indexing is the best way for many people to invest. To be assured of an average return before costs and an above-average return after costs, provided one selects a low-cost, broad-market index fund and stays the course, is a wise choice for those who prefer to focus their energies on something other than the stock market or understanding what makes a great business. Bogle’s “folly” is in essence a gift to the common investor, one that even the best of investors like Warren Buffett acknowledge and celebrate. Moreover, it is a distinctly American undertaking.

    Don Phillips is a managing director of Morningstar, Inc.