reduced . Diversification , such as can be achieved through a broad , passive portfolio of the entire stock market , is the only “ free lunch ” available to investors , Markowitz argued .
Markowitz ’ s thesis became the foundation for what is now called Modern Portfolio Theory ( MPT ) and would win him the Nobel Memorial Prize in Economic Sciences in 1990 .
The idea that an investor could reduce risk through diversification was now in the air . Another important impetus to indexing came in the mid-1960s , when Eugene Fama and others developed the Efficient Market Hypothesis . It held that asset prices reflect all available information , and because prices reflect all available information about the future payout of dividends and earnings , there is no good or bad time to enter the market .
These two concepts — Modern Portfolio Theory and the Efficient Market Hypothesis — combined to produce a powerful conclusion : The best way to reduce risk through diversification is to own the entire market . The issue was , how could that be accomplished ?
The Birth of Indexing
In the early 1960s , Ransom Cook , the chairman of Wells Fargo , attended an IBM conference in which a Smith Barney analyst , John McQuown , talked about using computers to pick stocks . McQuown had a degree in mechanical engineering from Northwestern University , and was keenly interested in statistical analysis of the stock market and how an index fund might be set up .
Cook was so intrigued he offered McQuown a job immediately . For the next decade , McQuown was a director of the Management Sciences Group at Wells Fargo , a think tank that reported directly to Cook . He eventually became the founder of Wells Fargo Investment Advisors , the bank ’ s investment advisory subsidiary .
The first index portfolio was begun in 1971 and funded by an unlikely source : the Samsonite luggage company ’ s $ 6 million pension fund . It was indexed to the 1,500 stocks on the NYSE , but the difficulty in managing the constant updating of 1,500 stocks caused Wells Fargo to soon set up a separate fund , this one indexed to the S & P 500 , and to fold the Samsonite fund into it .
Index investing pioneer and Vanguard Founder Jack Bogle .
An index fund was now in existence , but it attracted very little attention . Jack Bogle , who was also on a somewhat lonely quest to develop a fund tied to the S & P 500 , was aware of the efforts at Wells Fargo . In 1976 , he launched his own fund , the First Index Investment Trust .
But getting investors to sign on to a fund that merely mimicked the S & P 500 was no easy task ; fund managers openly ridiculed the idea , claiming that investors should be trying to beat the market , not merely perform in-line with the market . There was an additional problem : these funds could not be traded during the day .
Smart people began asking the next logical question : is there another way to buy , sell and own an index fund ?
The Birth of the ETF Business
The October 1987 stock market crash helped create the impetus for the next big development : the birth of Exchange- Traded Funds ( ETFs ). The SEC issued a long report analyzing the crash four months later and suggested that had investors had a market-based instrument like the S & P 500 that could be traded intraday , it might have mitigated the impact .
What they were describing was what became known as an Exchange-Traded Fund , which could wrap the 500 stocks of the S & P 500 into a single security and that could trade intraday , just like a stock .
Nate Most and Steven Bloom were listening . Most was head of product development at the American Stock Exchange , and Bloom was his right-hand man .
Princeton University Economist Burton Malkiel was a governor at the Amex and chaired the new products committee . When Most brought up the ETF concept , Malkiel enthusiastically endorsed the idea .
And with good reason . Malkiel ’ s 1973 book , A Random Walk Down Wall Street , had helped popularize the idea that stocks exhibit a “ random walk ” pattern , that it was not possible to consistently outperform the stock market and that investors were better off in broadly diversified index funds . In the 20 years since its publication , it had become an investment classic .
After several false starts and battles with the SEC and the Commodities Futures Trading Commission ( CFTC ), Most and Bloom joined forces with State Street Global Advisors to launch the Standard & Poor ’ s Depositary Receipt , the first USbased ETF , on January 29 , 1993 .
Like the Vanguard 500 Index Fund , the SPDR , as it came to be known , tracked the S & P 500 . But the ETF structure had several advantages over a mutual fund :
• It was structured as a Unit Investment Trust ( UIT ), which unlike a mutual
22 FINANCIAL HISTORY | Fall 2022 | www . MoAF . org