The Acorn
When I started working at Morningstar (MORNING), February 15, 1988, the atmosphere was subdued. Reeling from the 22% loss in shares on Black Monday (which remains the largest single-day drop in US stock market history), investors worried that the good times were over. Stock and bond prices had enjoyed a splendid five-year run from 1982 to mid-1987. Now, it seemed, normality would return.
Instead, the rocket arrived. The stock market has gone almost straight, year after year, with inflation and interest rates falling. Fund activity followed suit. Historically, something of an investment backwater—in the early 1980s, annual industry revenues were under $500 million—mutual funds hit the mainstream. Everything was very exciting. I was especially happy because soon after joining the company, I ignored the skeptics and put everything I had (not much) into a fully invested equity fund.
In the early years, Morningstar analysts reported on every equity fund out there, including the $5 million Valley Forge Fund, managed by a husband-and-wife team. (“Bernie can’t come to the phone right now. Can I ask him to call you back, after he’s finished mowing the lawn?”) To attempt the same feat today would require a much larger search party. Including exchange-traded funds, the number of equity funds increased eightfold.
Money, money, money
Although impressive, the increase in the number of funds was much less than the surge in fund assets. In 1988, the largest mutual fund was Franklin US Government Securities (FKFSX), which ended the year with $11.7 billion. (Right behind was another bond fund, Dean Witter US Government Securities Trust (USGAX)which has since been renamed after its current owner as Morgan Stanley US Government Securities.) Today, 348 mutual funds and 124 ETFs exceed that figure.
The following chart, comparing mutual fund assets in 1988 to those of 1) mutual funds and 2) ETFs in 2021, effectively conveys the story. When I arrived at work, the progression of the industry was just beginning.
Yes, these numbers are not adjusted for inflation, but that would only bump the 1988 figure up to $1 trillion. That first year would still barely be on the chart.
The Index Revolution
Besides breathtaking growth, the other remarkable development of the funds was the triumph of indexing. In 1988, three index funds existed: 1) Vanguard 500 Index (VFINX)2) DFA US MicroCap (DFSCX)and 3) an all-new Fidelity entrant that was eventually merged into the company’s current offering Fidelity 500 Index (FXAIX). (Even that list is suspect, because DFA now claims its funds are actively managed. However, since it called DFA US Micro Cap an index fund at the time, that’s where I put it.) In total, these funds held $2 billion, representing a market share of slightly less than 0.5%.
Today, index funds make up more than half of equity fund assets and just over 40% of the industry as a whole. This percentage exceeds my seemingly ill-considered prediction from the early 1990s that indexers could eventually control 30% of fund activity, which I had casually offered to a Money journalist. It became the main quote of the story. Active managers were, shall we say, indifferent.
The price is right
The progress of index funds has been accompanied by greater awareness of the costs of funds. At the time, investors who focused on spending funds were considered eccentrics. Life was too short to worry about a few basic points. In 1993, for example, the top five selling mutual funds averaged an average expense ratio of 1.09%. When performance was strong, price was no obstacle.
This attitude has changed dramatically, as evidenced not only by today’s best-seller lists – which are dominated by index funds – but also by the industry’s dollar-weighted average spend ratio, which reflects where the investors now own their money. This has fallen sharply, from 0.74% for all stock, bond and allocation funds in 1988, to 0.41% for mutual funds today, and to 0.17% for ETFs. Where direct investors and financial advisors once downplayed the importance of price when evaluating funds, they now put expense ratios front and center.
Granted, all-in costs for fund investors haven’t fallen as drastically as the numbers seem to indicate. Today’s financial advisors are compensated differently. Where once paid almost exclusively by fund companies, which built sales charges into their products, advisors now primarily charge asset-based fees. So many fund investors are paying more than the numbers suggest. On the other hand, their interests are now aligned with those of their advisors. For each part, the cheaper a fund, the better.
Indeed, having become discounters, financial advisers favor institutional shares. After all, why should their clients pay more, when advisors can use their insider status to land better deals? The fact that the industry has become so large, with top advisors placing tens of millions of dollars in a single group of funds, has enhanced their bargaining power. As a result, fund companies have increasingly made their institutional shares available to everyone.
glory day
The rise of the fund industry has greatly benefited Morningstar. So my career has been blessed. While most people of my generation did not enjoy similar working conditions, all had the same tremendous investment opportunity. Fund activity was not the only activity to exceed expectations. The same was true for stocks and bonds, which easily outpaced inflation. Those who held bonds benefited. Those who held stocks fared even better. Many have become richer than they ever imagined. The table below provides the details, for the 33.5 years that have passed since August 1, 1988.
Whether the next generation will enjoy similar investment success remains to be seen. The consensus is different. Most institutional researchers expect post-inflation returns for stocks and bonds over the next third of a century to be much lower than those of the most recent third. It may well happen; I don’t argue with forecasters. However, it’s worth remembering that when my personal journey began, the wise old heads sounded the same note. As Yoda would say, they were wrong.
Happy holidays and may your fortune be as generous as mine has been.
Editor’s note: The reference after part 2 to the 1988 figure has been corrected to trillions, not billions.
John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar generally agrees with the opinions of the Rekenthaler report, his opinions are his own.
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