Exchange Act of 1934 outlawed market manipulation and insider trading . Recognizing that the end of a nearly 150-year era was upon them , the famed stock operator William Durant lamented : “ We may as well tell the truth and put the blame where it belongs . It ’ s up to Washington now . We have stepped aside .”
The Servants Become the Masters of Wall Street
“ The infant profession of securities analysis obviously prospered by [ securities reform ]. Indeed , if the profession can be said to have had ‘ founding legislation ,’ then this clearly was it .”
— Timothy C . Jacobson , author of From Practice to Profession : A History of the Financial Analyst Federation and the Investment Profession ( 1997 )
Benjamin Graham , who is often regarded as the father of the value investing philosophy , began his career on Wall Street as a statistician at a brokerage firm in 1914 . At the time , statisticians were considered lowly employees . They spent their days tucked away in back offices where they sifted through reams of paperwork to collect basic data on stocks and bonds . Brokers considered this information necessary , but far less valuable than insider information . After the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934 , however , the skills of statisticians were suddenly in high demand . Market manipulation and insider trading were illegal ; companies were disclosing massive amounts of information and few investment professionals had the skills to make sense of it .
In the early 1920s , Graham launched his own investment management firm . He was fortunate to have voluntarily shunned market manipulation and insider trading even though it was legal . Instead , he relied solely on his relentless due diligence to parse through publicly accessible information and profit by finding value that others had overlooked . Graham developed a strong track record during the 1920s , which earned him a reputation as one of the leading investors in the post-securities reform era . He documented his techniques in his books Securities Analysis and The Intelligent Investor . He also became a leading voice among a loose confederation of financial analysts that eventually evolved into the CFA Institute .
The Golden Age of Financial Analysis
The 1950s and 1960s were a time of plenty for the emerging financial analyst profession . Securities markets were flooded with new issues after World War II , and the population of trained securities analysts was limited . But within a few decades , the supply began to exceed the demand . In 1963 , the first 268 individuals received a CFA charter ; by 1979 , the cumulative number of CFA charters exceeded 6,000 . Moreover , this was only a small percentage of the number of investment professionals analyzing securities each day . By the 1970s , the wisdom of the crowd presented a formidable challenge for analysts . Finding information that was not baked into market prices was a rarity .
During the 1970s and 1980s , leading academics and investment professionals also began studying the performance of securities markets . A common observation was that comparable market indices consistently outperformed actively managed investment funds . Further , as the time horizon of analysis lengthened , the number of outperformers contracted . This phenomenon is observed in every game of chance , as luck explains the outperformance of gamblers over short periods of time . Just like the number of winners at a roulette table dwindles with each turn of the wheel , the number of successful active fund managers dwindles with each passing year .
The Flaw of Large Numbers
“ An investment trust should be good and large , because this tends to make the expenses of running it a negligible percent of the whole . But when the trust is big in size , the investing problem becomes increasingly difficult .”
— Fred Schwed , Jr ., author of Where are the Customers ’ Yachts ? ( 1940 )
Over the past several decades , actively managed funds have continued to attract new investors even though index funds have steadily gained market share . Figure 1 shows the total assets under management ( AuM ) of actively and passively managed mutual funds in the United States
An Inconvenient Truth and the Birth of the Index Fund
“ My basic point here is that neither the Financial Analysts as a whole nor the investment funds as a whole can expect to ‘ beat the market ,’ because in a significant sense they ( or you ) are the market .”
— Benjamin Graham ( 1963 )
By 1963 , Benjamin Graham concluded that the golden era of the financial analyst had ended . This did not mean he had lost faith in the overall value of the profession ; he just knew with mathematical certainty that beating market averages was no longer a worthy endeavor for most analysts . Graham was not only convinced by the logic , but he was also persuaded by the evidence . For example , in 1940 , the SEC observed that even in the relatively inefficient markets of the 1920s and 1930s , most actively managed funds failed to outperform a 90-stock index . Many studies that followed by Nobel laureates and famed academics — such as Eugene Fama , Burton Malkiel and William Sharpe — produced the same results .
Despite the irrefutable evidence , Graham ’ s message was largely ignored . By the 1960s , there were simply too many firms and individuals who had wagered their businesses and careers on denying this reality . Despite a clear need for a low-cost fund that simply mirrored the performance of a market index , it was not until 1976 that Jack Bogle popularized index investing with the launch of the Vanguard 500 Index Fund .
www . MoAF . org | Summer 2024 | FINANCIAL HISTORY 25