A Second Challenge to Judgment

The first edition of the Journal of Portfolio Management opened with an article from its founder and editor, the great Peter Bernstein. In What this Journal is Abouthe wrote:

The maiden issue of this Journal appears at a critical time for our profession. The dismal of record of portfolio management over the past five years needs no elaboration…Our profession probably receives a wider variety of information from more sources than any other group in the world. While few people today can place any real confidence in an earnings estimate and while even fewer can use research on individual companies as a successful basis for stock selection, most analysts keep grinding out the material almost as if nothing ever happened.

Later in the journal, Paul Samuelson shared similar thoughts which were delivered in a more scathing tone. He penned what would become one of the most important pieces ever written on the topic in Challenge to Judgment.

In this no-holds barred article he wrote:

A respect for evidence compels me to incline toward the hypothesis that most portfolio decision makers should go out of business- take up plumbing, teach Greek, or help produce the annual GNP by serving as coporate executives…Some large foundation should set up an in-house portfolio that tracks the S&P 500 index- if only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess.

The ball, as I have already noted, is in the court of those who doubt the random walk hypothesis. They can dispose of the uncomfortable brute fact in the only way that any fact is disposed of – by producing brute evidence to the contrary.

What makes this worthy of a place on the Mount Rushmore of financial articles is because of how it influenced one of its readers, Jack Bogle. Samuelson confirmed what Bogle wrote in his senior thesis, mutual funds “may make no claim to superiority over the market averages”. Saint Jack was so moved by Samuelson’s words that he decided to go for it. In a world lit only by active mutual funds, he had the courage to try something different. Bogle later said, “He laid down an express challenge for somebody, somewhere to start an index fund . Presented with that challenge, I couldn’t stand back any longer.”

With over $6 trillion in assets and hundreds of billions of dollars of saved investing fees, the index fund is the greatest invention in the history of investing products. But now, its creator fears that there may be some unintended consequences. Yesterday in The Wall Street Journal, Bogle wrote:

If historical trends continue, a handful of giant institutional investors will one day hold voting control of virtually every large U.S. corporation. Public policy cannot ignore this growing dominance, and consider its impact on the financial markets, corporate governance, and regulation…It seems only a matter of time until index mutual funds cross the 50% mark. If that were to happen, the “Big Three” might own 30% or more of the U.S. stock market—effective control. I do not believe that such concentration would serve the national interest.

Bogle provided a list of possible solutions, none of which sound remotely viable. I do think he brings up a good point here, but I’ll admit that I’m not sure what exactly what some of the adverse consequences are of this concentration. Time will tell if this is making a mountain out of a molehill, or if the industry needs a second challenge to judgment.