First published in 1843, the tale created by Hans Christian Anderson about the Ugly Duckling is a well-known fable that many of us heard during our childhood. The Ugly Duckling is a fictional fairy tale. The story is about a homely little bird born in a barnyard who suffers through mocking and abuse from his fellow fowl until, much to his delight and to the surprise of others, he matures into a graceful swan, the most beautiful bird of all. It is a story of transformation for the better, and not being afraid to be or look different.
In the early 1970s, when the first idea of a “market-based” or “indexed” approach to investing was conceptualized, it suffered through years of an ugly duckling experience. David Booth and Rex Sinquefield, the founders of Dimensional Funds in 1980, actually were part of the creation of the first index funds for Institutional Investors at Wells Fargo and American National Bank & Trust, respectively. A few years later, John Bogle, founder of Vanguard, created the first publically-available index strategy.
Initially, like many ideas that challenge the norm, these efforts were mocked by much of traditional Wall Street for being and looking much different than what existed in the investing world at that time. They were derided and referred to as “un-American,” “ socialist investing,” a “cop-out settling for mediocrity” to name a few.
Of course, the merits of adhering to a market-based approach to investing have proven to be far from any of those labels. In fact, in any given year, roughly two thirds of active money managers who seek to beat their index by stock selection or market timing fail. Over longer time horizons, the chance of out-performance gets worse. There will be those who beat the market every year, but actually fewer than you would expect from random chance. It is impossible to identify in advance those who may out perform in the future, and for those who do, it can’t be readily determined if they were skillful or just plain lucky.
Market-based investing has come a long way since its Ugly Duckling days in the early 1970s. Steadily, as investors have clamored for lower costs and greater diversification, market-based investing has taken hold and now represents anywhere from 25 to 30 percent of the investing marketplace. Being different and challenging the status quo can be a difficult road, filled with criticism and headwinds. But in this case, market-based investing, once the Ugly Duckling of the investing world, has transformed into a beautiful swan – and the envy of many an active manager.