A conversation with Nobel laureate William F. Sharpe about indexing

Index investing was considered anathema to all but a handful of industry insiders when the first index mutual funds launched in the 1970s.

Nearly 50 years later, it’s clear these pioneers were on the right side of history. The intervening years have shown that indexing — the practice of investing in diversified baskets of stocks or bonds with the aim of tracking the performance of broad markets — can deliver low-cost, efficient market access and returns that compare favorably with “active,” or alpha-seeking managers.1 Asset growth of index funds from 2009 - 2019 has been astounding: Index mutual funds and index exchange traded funds (ETFs) together accounted for 39% of assets in U.S. funds at the end of 2019, up from 18% at the end of 2009.2

William F. Sharpe, Nobel laureate in economics (1990) and emeritus finance professor at Stanford University, has made innumerable contributions to the practice of investing, including the development of the eponymous Sharpe ratio — a measure of risk-adjusted return — and the Capital Asset Pricing Model (CAPM). He is a founding father and longtime advocate for indexing.

His work helped spur the creation of the first index fund, in 1971, for the Samsonite pension fund, run by a Wells Fargo indexing unit. It was later sold to Barclays and became the iShares legacy.

Sharpe joined Daniel Prince, head of iShares product consulting for BlackRock's U.S. Wealth Advisory business and head of U.S. iShares Core ETFs, and Chris Dieterich, editor of iShares.com, for a wide-ranging conversation about how he thinks of his legacy, the early struggles to advance index investing and the influence his work has had on today’s investors. The conversation took place over video call, with Sharpe joining from his home in Carmel-by-the-Sea, Calif. The interview was edited for brevity and clarity.

DANIEL PRINCE: Bill, it’s an extreme honor to have a conversation with you. Much of my career is rooted in your theories, and a lot of my dozen or so years at BlackRock has involved promoting market-cap weighted indexes and education with financial advisors about owning the market.

My first question concerns a short paper you wrote back in 1991, “The Arithmetic of Active Management,” which laid out a big challenge that faces alpha-seeking managers.3 The conclusion was basically that, on average and after deducting management fees, the average active investor must underperform passive investors. This idea continues to influence how our clients think about portfolios — can you tell me how your career led to this piece, and more about its origins?

WILLIAM F. SHARPE: Well, it goes back to my dissertation in 1961 that led to my paper in 1964 on the CAPM which was a model showing that expected excess return for a stock was a linear function of the sensitivity of its return to market moves.4 From this came the argument for why you should own the market portfolio, a portfolio of equities in market proportions.

I argued that with many people for many years. And I guess “Arithmetic” came out of teaching. I thought, well, there’s a much simpler argument for the market portfolio of all securities in market proportions. The point is just that active management typically costs more than passive management. The rest is simple arithmetic.

CHRIS DIETERICH: You make a couple of deceptively simple points in this piece. The first is that, before costs, “the return on the average actively managed dollar will equal the return on the average passively managed dollar.” In other words, the math shows that the market cap-weighted index represents the average return of all investors before costs.

The second is that after costs are considered, “the return on the average actively managed dollar will be less than the return on the average passively managed dollar.” In other words, indexes should outperform the sum of alpha-seeking investors after costs.

SHARPE: I’ll tell you what I used to do with a general audience. I start by dividing them in half – 50% are going to be passive managers; the rest are going to be active managers. Then I tell them what this means.

I go through the ritual and when you get to the punchline about the average dollar there’s sort of a reaction of incredulity on the part of the audience: “Wait a minute, that can’t be right.”

It’s the simplest argument that I’ve ever made in any publication. And it’s just hard to refute.

PRINCE: It’s important to note that you’re not saying beating the market is impossible.

SHARPE: There’s nothing in the arithmetic that says some active managers cannot outperform after costs; it’s just a matter of whether you or your consultant can find them; of course, some managers may have strong track records against appropriate indexes.

So it’s not to say active managers can’t beat the market or their bogey or index. They may even do it repeatedly, but what we know is that very few do it for very long.

DIETERICH: When you look back at “Arithmetic,” what do you think its legacy has been? In addition, of course, to being a triumph of brevity at just about two pages in length.

SHARPE: As with all my work, I think the influence is less than I would have wished it to be. But there have been people who would introduce me at meetings by saying it was the most important paper in finance – which I hope is not true, because it doesn’t speak well for finance or for that matter the rest of my work.

I’ve argued for low-cost, broad index funds from the start. I thought of this one as a sort of ancillary document that was a self-evident part of earlier ones, which of course were more elegant. But life is often about simplifying assumptions. Part of the reason for this was to take this contrarian argument and make it a little more public.

PRINCE: On a related topic, we’ve learned that often indexes allow investors to control “frictions,” things that can eat into returns. I’m talking about things like turnover and fees. Our recent research shows, using Morningstar data, how strong performance can be over time if you eliminate frictions.

SHARPE: A mistake people make is around the fact that expense ratios used to be 1% or 2% and now they are more like 50 basis points.5 People might say, half of a percent, big deal. They would fail to say, wait a minute, if I’m down half a percent per year that there’s a compounding effect.

Half a percent is a big deal. Let’s see after 30 years where you are.

PRINCE: Absolutely. We just ran some numbers to see the impact fees can have on an investor's portfolio over time, and it's significant. A hypothetical investment of $100,000 made 20 years ago assuming a 10% annual rate of return at an expense ratio of 0.10% would have grown to about $660,000 this year. But change the expense ratio to 0.91%, which is the average net expense ratio of active open-end mutual funds, and the investment would have only grown to about $569,000. That's a difference of over $90,000!6 Lower fees are a contributor to that outperformance and no doubt play an important role in building portfolios for the long term.

DIETERICH: Let’s put the academic work in practical terms. For someone who has just graduated from college, say, and is hoping to enter the workforce and start to save money and invest, what does your work say they should do?

SHARPE: Index. Be broadly diversified with low cost. The question is how you mix a “safe” asset with this “risky” asset depends on — among other things — your job. If you work in tech, then maybe it makes sense to underweight tech stocks in your portfolio. But many people in tech do just the opposite.

I personally espouse a broad portfolio of world stocks and bonds as a risky portfolio and a riskless portfolio made up of TIPS [Treasury Inflation-Protected Securities].

Think about duration. If you’re young and considering retirement, you should probably consider 30-year TIPS if you can find them. Of course, that’s wildly oversimplified.

DIETERICH: Your website has some old, satirical videos on YouTube that deal with finance topics and one caught my attention. It pokes fun at ETFs a bit — how do you feel about the structure these days?

SHARPE: At that time I really did not follow ETFs. What I did know was that a lot of people used ETFs for what I would call day-trading, and similar speculative purposes.

I had not invested in them until fairly recently. Then I started looking for really diversified ETFs, things like world bonds and world stocks. More recently I’ve been looking at ETFs that own TIPS, looking at them and their cost.

And even though they are traded a lot, I have no prejudice against them anymore. In fact, I recently bought some ETF shares.

PRINCE: It’s interesting because some of our fastest-growing users are asset managers, basically professional active investors, either for liquidity or to enact their tactical views. But in my career, I’ve seen a sea change in terms of perceptions around the role of ETFs. In the early 2000s, it was along the lines of what you described; now ETFs are thought of more as important tools for long-term investor portfolios.

SHARPE: I’m a convert. And while I’m agnostic about [fund] structure, it’s fascinating to watch the development of ETFs.

DIETERICH: Let’s take the long view. Describe what it was like then to be a champion of indexing earlier in your career, back in the 70s and soon after, and what was the most common reaction you received from the fund industry?

SHARPE: When I started doing my work, the vast majority of Americans didn’t know what a mutual fund was. They were sort of arcane things, something that rich people or strange people invested in. Ordinary people had almost no contact with securities and investments. Retirement plans were defined benefits, and outside work you generally weren’t able to save that much; what you did save you put in the bank.

But within the industry, we academics were considered the enemies of everything that was right and godly. There were people who took out full-page ads saying that indexing is unpatriotic.

PRINCE: Do you feel at this point like you’ve won the intellectual argument?

SHARPE: I’ll declare a victory. And it’s been a trip. Never in my wildest imaginings would I have expected anything like what has happened with indexing. It’s been astounding.

PRINCE: Thanks so much for chatting with us.

Daniel Prince

Daniel Prince, CFA

Head of iShares product consulting for BlackRock’s U.S. Wealth Advisory Business and U.S. Head of iShares Core ETFs

Contributing author: Chris Dieterich