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In 1900, farms were small, inefficient, and labor-intensive. About 41% of the workforce labored in jobs such as field hand, egg chandler, and hay baler. Food was expensive. The typical household spent 43% of its income on sustenance.1

Over the next century, tractors replaced horses; researchers developed higher-yielding grains and new irrigation and fertilization techniques; railways and highways created a national distribution network. Output soared, food prices plummeted, and labor left the farm for better opportunities. Today, the typical household spends less than 10% of its income on food, produced by less than 2% of the workforce. 2

A similar story of miraculous productivity gains and astonishing price declines reshaped just about every corner of the U.S. economy in the 20th century except one: financial services. Such is the dismal conclusion of a 2015 paper by New York University’s Thomas Philippon, Has the US Finance Industry Become Less Efficient?

A price and productivity puzzle

In 1900, according to Philippon, costs in the U.S. financial services sector amounted to roughly 1.6% of “intermediated assets”—the savings, loans, and securities that underwrite investment and grease the wheels of commerce (in short, any financial asset that isn’t stuffed under a mattress). More than a century later, those costs amount to . . . roughly 1.6% of assets.

“It’s puzzling,” Philippon writes. “Advances in information technology should lower the physical transaction costs of buying, pooling, and holding financial assets.” Possible solutions to the puzzle include growth in household borrowing (households are more expensive to serve than corporate borrowers) and growth in the asset management industry, particularly as “high-fee alternative asset managers have gained market share.”

I suspect that Philippon’s data set, which runs from 1870 to 2012, ends too soon. That’s because the asset management industry is only now beginning to realize the efficiencies generated by one of the greatest innovations of the late-20th century: the index fund.

The first unicorn

When the first index mutual fund for individual investors began operations on August 31, 1976, Jack Bogle’s brainchild was a curiosity, a provocation in a largely academic debate about whether professionals could consistently outperform the market. It wasn’t even all that cheap, with a sales load and expenses equal to 0.43% of assets at the end of its first fiscal year.

As its assets under management increased, however, the innovation’s potential to grind down unit costs became clear. Like a Silicon Valley “unicorn,” the technology was scalable. In 1976, when fund assets totaled a little more than $14 million, annual fees for a $10,000 account were about $43. At the end of 2015, with more than $219 billion under management, fees for the same-sized account were just $5, an 88% reduction in unit costs.


Vanguard 500 Index Fund: A technology that can scale

500 index fund scale - Total Net Assets - all share classes500 Index Fund Scale - Expense Ratios - for a $10,000 investment
Source: Vanguard


Indexing’s cost-crushing scalability reflects, in part, its relatively low labor intensity. At the end of 2015, according to Morningstar data, the average stock index fund held more than $12 billion in assets, overseen by an average of 2.2 managers. The average actively managed fund, which requires more hands to evaluate individual investments, held just $2.2 billion in assets, overseen by an average of 3 managers.

These differences in labor efficiency show up in the prices we pay. At the end of 2015, the industry’s stock index funds had an asset-weighted expense ratio of 0.11%, according to the Investment Company Institute (ICI). Active strategies charged 0.84%.

Cost in the crosshairs

Indexing is now a well-established—and highly regarded—investment strategy, but it’s still in the early stages of adoption. At the end of 2015, according to the ICI, index strategies accounted for about 30% of mutual fund and ETF assets, with especially strong growth since the global financial crisis.

Like Cyrus McCormick’s mechanical reaper, indexing has emerged as a technology to reduce the cost of harvesting interest payments, dividends, and capital gains from the financial markets. And by putting cost at the center of the conversation, indexing seems to be having beneficial spillover effects on the higher-cost strategies that have gained market share over the past few decades, according to Philippon.

Scan the trade press, and you’ll see headlines about pressure on alternatives managers to lower their fees. In the mutual fund industry, investors are voting with their feet. As my colleagues David Walker and Don Bennyhoff have noted, new cash flow is going overwhelmingly to the lowest-cost funds, index and actively managed.

The trend may not yet be visible in Philippon’s data, but asset management costs are coming down, and indexing is the catalyst.


1 Robert J. Gordon, 2016. The Rise and Fall of American Growth. Princeton, N.J.: Princeton University Press.

2 Carolyn Dimitri, Anne Effland, and Neilson Conklin, 2005. The 20th century transformation of U.S. agriculture and farm policy. Washington, D.C.: U.S. Department of Agriculture. (Economic Information Bulletin Number 3.)

3 Thomas Philippon, 2015. Has the US finance industry become less efficient? American Economic Review 105(4):1408-38.