Index funds are pervasive now. We wouldn’t have our momentum program without them. But did you ever wonder how and when the very first index fund started? Many think it was in 1971 when Wells Fargo (which became Barclays Global Investors before being acquired by Black Rock in 2009) put $6 into every stock on the NYSE for the Samsonite pension fund. But that’s not correct. Let me tell you how it really began.
In 1976 I was with Smith Barney & Co. At that time Smith Barney was a prestigious investment banking and institutional brokerage firm along the lines of Morgan Stanley or First Boston. However, the firm wanted a retail distribution network, so they acquired Harris Upham, a predominantly retail oriented firm. As is usual after these kinds of acquisitions, Smith Barney let go of the redundant operations of Harris Upham. However, Harris Upham had one of the very best Over the Counter (OTC) market makers in the business, so Smith Barney was happy to keep him. I’ve long forgotten his name, so let’s just call him John.
In those days, there was no electronic marketplace. In order to buy or sell OTC securities, you had to phone around to different brokerage firms and check the bid/offer spreads maintained by their market makers. A top notch OTC guy could become a terrific brokerage firm profit center. This was not just because the bid/offer spreads of OTC securities were sometimes large enough to drive a small vehicle through. The best OTC market makers made plenty of bucks from their acumen in maintaining inventories of OTC stocks. They could slant their bids and offers so they ended up with large positions in stocks they liked and small positions in those they disliked. John was one of the best stock pickers in the business. Top institutional investors would deal with him in order to find out what he liked or disliked, and to execute their trades using the large, liquid inventories that John routinely maintained.
Smith Barney was proud to have John on board. They sent him around to all their offices so we could learn more about John and feel comfortable sending business his way. One day John showed up at our office and spent an hour explaining what he did. He impressed all of us with his expertise and accomplishments. When he finished his talk, we congratulated and complimented him. As we were about to adjourn for lunch, someone said how much he admired John’s trading abilities. John sat back in his chair, paused a moment, then remarked, “Yes, I’ve done very well, but would you like to hear about someone who’s done even better… in fact, someone who is the best investor that I know?”
Everyone froze in their tracks. “Sure!” we said as we all settled back into our chairs. John continued, “The greatest investor I know, the one who has outperformed every professional portfolio manager that I’m aware of, is … my wife, Mary. Would you like to hear how she does it?”
You could have heard a pin drop. During the stunned silence, if an eight hundred pound gorilla had entered the room, no one would have noticed. Here was one of the industry’s top traders and market makers, who did business with the world’s best money managers, telling us that his wife was better than all of them. And he was about to tell us how she did it!
John continued, “Mary has always been very patriotic. So years ago she decided to buy all the stocks with U.S. or American in their names. So she bought U.S. Steel, U.S. Shoe, U.S. Gypsum, U.S. National Bankshares… American Brands, American Can, American Cyanamid, American Electric Power, American Express, American Greetings, American Home Products, American Hospital Supply, American International Group, American Locomotive, American Motors, American South African, American Telephone & Telegraph, British American Tobacco, North American Aviation, Pan American Airlines, and many smaller companies.”
We didn’t know if John was serious or putting us on. But John wasn’t smiling. He seemed sincere and continued, “After a number of years, Mary did so well that she decided to buy all the Generals – General Dynamics, General Electric, General Mills, General Motors, General Maritime, General Steel, General Telephone, Mercury General, Media General, Portland General, etc… Mary’s done better with her portfolio than anyone I know, and that’s the God honest truth.”
Everyone was highly amused as we adjourned for lunch. But I couldn’t stop thinking about Mary. I kept asking myself how she could have outperformed the world’s top money managers over such a long period of time. Then it became clear to me. First, Mary’s portfolio had relatively little in the way of transaction costs. She bought stocks only once and held on to them forever. Commissions were much higher back then, but that wasn’t the whole story. Mary also didn’t pay any management fees. That saved her at least 1% a year compared to mutual funds and other actively managed investment programs. And finally, Mary’s portfolio was well diversified. Most actively managed portfolios then were biased toward a particular investment style, such as growth, glamour, large cap, etc. Deviations from the market portfolio create risk. Mary’s portfolio was like the entire market - equally balanced among small cap, large cap, value, growth and every other factor. If anything, her randomly selected portfolio had a value and small cap tilt, compared to the general market. Mary had created the world’s first index fund, without the need of brokers, money managers, or anything else… other than a dictionary. After thinking deeply about what Mary had done, I decided to leave the brokerage business.
