stock market boards arranged as tunnel with light at end

What a difference a day makes. And if you think that's something, just imagine what a difference two days make.

Forget days. What about a decade? This is the problem with thinking any one investment philosophy is the end all and be all. This is the problem with index funds. This is a problem 401(k) plan sponsors can no longer ignore (see "When Do Index Funds Raise A Fiduciary Issue With 401k Plan Sponsors?" FiduciaryNews.com, February 25, 2020).

Let's take a brief trip down history lane. For those too young to have lived it, building index funds was considered "impossible" in the 1980s. I know, I know, you're all thinking, "But didn't Bogle start the first index fund in 1974?"

Yes, he did. But that didn't prevent MBA professors from saying the trading costs, tax consequences, and the logistical constraints of mass trading prevented anyone from building a fund that could reliably and consistently duplicate the returns of any index.

The world began to change in the 1990s when systems upgrades within back office operations and the slow death of brokerage commissions began to accelerate. At the same time, those same MBA professors who dissed index funds had convinced themselves, their students, and the industry to bend to the altar of Modern Portfolio Theory.

With more efficient trading systems, index funds became viable. The debate moved from the classroom to the boiler room. And the 1990s provided the perfect market to fertilize the growing index fund industry. By the end of the decade, their popularity grew beyond the bounds of mere market share. Index funds could do no wrong.

But then the tech bubble burst. And for a long 10 years – the "Lost Decade" – index funds wallowed in desperation. It didn't help we saw two dramatic market drops within nine years after the turn of the millennium. By the end of that decade, the average active fund far exceeded index funds.

That smaller market share index funds held during that awful period turned out to be an advantage. Quite simply, not enough investors experienced the Lost Decade because most remained in active funds.

But then the pendulum swung the other way. As we recovered from the 2008-2009 recession, while slow on a historic basis, index funds began to do better. This made sense because they had fallen so much farther. (For those unfamiliar with it, look up the meaning of the term "dead cat bounce.")

As index fund returns showed greater positive separation from active funds, it drew greater interest. That greater interest generated greater inflows into passive funds. That constant reinvestment within underlying index stocks pulled up index returns by their own bootstraps.

By the end of last year, the market share of passive investments exceeded that of active funds. What Jack Bogle once told me would never happen had happened.

And now, the end of index funds is near.

That's a safe prediction. The pendulum never stops swinging. It seems it swings from active to passive and back to active every 10 years.

We're right on schedule.

Only this time, when the index returns significantly lag actively managed funds, a lot more investors will experience this first hand.

And they won't like it.

If you want a prediction, here it is. From a behavioral perspective, people need to blame something for a systemic loss. They often find a suitable scapegoat in that thing that held out so much promise.

In the past, that thing was portfolio managers of actively managed funds, paving the way for index funds to fill that void. This time around, index funds shoulder the blame.

Will that blame be a temporary blip or a permanent scar? That all depends on what's waiting in the wings to replace the scapegoat. Active funds survived earlier bouts because there was nothing to replace them. Once index funds had matured, when the time came to find a replacement for the disgraced active fund, the index fund was now ready and willing.

Is there an alternative to index funds right now? It can't be active funds. They're damaged goods.

But a movement is growing on the horizon – a new hero, if you will. It is the ESG fund.

The beauty of the ESG fund is that it is not exclusively an active or a passive fund. It can be either, so the claim could be made it can possess the advantages and disadvantages of both, but with a unique differentiator.

After all, what we're talking about here – what we've been talking about whenever we talk about this – isn't about the investment theory, it's about the selling proposition.

READ MORE:

Instant Insights /

Is this the end of index funds? – Carosa

More From HR Executive

Related Stories

Recommended For You