Morningstar Magazine - August/September 2017 - 10

Dispatches

Indexing in America
Tocqueville told us
why it would take root
in a democracy.
PHILLIPS CURVE

Don Phillips

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

Morningstar August/September 2017

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. K
Don Phillips is a managing director with Morningstar.
He is also a member of the editorial board
of Morningstar magazine.

Table of Contents for the Digital Edition of Morningstar Magazine - August/September 2017