A revolution of sorts started on this date 35 years ago. On August 31, 1976, John C. Bogle launched the Vanguard 500 Index Fund (VFINX), a mutual fund that holds all the stocks in the Standard & Poor’s 500 index. Originally known as the First Index Investment Trust, it was the first fund to let individual investors own the broad stock market rather than actively trying to beat it. “It was a seminal event in investing,” says Dan Culloton, associate director for fund analysis at Morningstar. “It introduced passive investing to retail investors and eventually started a slow and steady revolution that continues today.
In truth, that revolution started in the 1960s with the efficient-market hypothesis championed by economists Eugene Fama and Paul Samuelson and popularized by Burton Malkiel in his 1973 book, A Random Walk Down Wall Street. That theory, which holds that stocks are rationally priced, provided the philosophical underpinnings for simply buying and holding the entire basket of publicly available stocks.
It took a while longer for the idea of investing in indexes to catch on—and Bogle wasn’t the first to promote it. Starting in the late 1960s, William Fouse—known as the “father of indexing”—and John McQuown worked at Wells Fargo to develop an index fund for large institutions. In the early 1970s, Dean Lebaron and Jeremy Grantham at Batterymarch Financial Management also pursued index investing. But Bogle’s mutual fund opened the concept to the general public and focused on providing a low fee structure to prevent returns from being eaten away.
Investors didn’t exactly rush in to buy Bogle’s fund when it first became available. It opened with $11.4 million in assets (some $43 million in today’s dollars), well short of Bogle’s original goal of $150 million. Other money managers were dismissive, if not hostile. Bogle, who founded Vanguard Group in 1974, has said that he heard the fund derided as Bogle’s Folly “all too often from the late 1970s through the early 1990s.” Others reportedly called it un-American. “Some of the early critics of index funds said you’re not trying to identify the best-performing stocks, you are aiming deliberately for mediocrity,” says Robert Arnott, the former editor of <em>The Financial Analysts Journal</em> and founder of Research Affiliates, an investment management firm that offers its own twist on traditional index funds. “Jack Bogle very sensibly said, you know you’re absolutely right, we’re aiming for mediocrity—unfortunately, that’s better than most active managers.”
Active money managers, more often than not, fail to beat the market—and many investors even today may not appreciate the extent to which management fees paid to those active managers wind up eroding their returns. “There’s a very strong argument that just getting the market rate of return is actually a very attractive proposition for investors,” says Vanguard Chief Investment Officer Gus Sauter. “After costs, the average investor no longer gets the market rate of return; they get the market minus costs. And the marginal outperformers become underperformers after costs. A majority of investors will underperform the market rate of return because of that.”
As index funds have shown their value, investors have increasingly shifted their money into them. The Vanguard 500 Index Fund reached $1 billion in assets in 1987, some 11 years after its launch, and ballooned from there to become the world’s largest mutual fund for a time. “The big growth really happened starting at about 1995 and on for the next five years when really large cap stocks outperformed quite dramatically and the S&P 500 performed extraordinarily well,” says Sauter. “Investors started taking a look at S&P 500 index funds because of the tremendous outperformance relative to traditional active managers.” The fund still has $105 billion in assets. Vanguard itself now manages about $1.7 trillion in assets, with some 55 percent of that in passive index funds.
Index funds boomed well beyond Vanguard. More than 360 index-based stock and bond mutual funds were available to investors as of last year, and assets in those types of funds have swelled from $27 billion in 1993 to more than $1.4 trillion as of June, according to the Investment Company Institute. Exchange-traded funds—which track an index but are traded like stocks—have also proliferated and exploded in popularity in recent years, with nearly 1,000 now on the market.
In all, investors have poured $2.3 trillion into passive funds and ETFs, according to Morningstar. That’s still far behind the $7.2 trillion in actively managed funds. But index funds are growing faster and attracting more money than actively managed funds. For the 12 months ending in July, $189 billion flowed into passively managed funds and ETFs, compared with $105 billion for their actively managed counterparts.
Money-management companies have taken indexing in a host of different directions, challenging the original idea of owning the broad market. The indexing movement has been splintered into scores of smaller offerings, with mutual funds and, in particular, ETFs, that slice and dice the investable universe into narrow bits. “People are really just throwing anything at the wall to see what is going to stick,” says Morningstar’s Culloton.
Companies such as Arnott’s Research Affiliates and Wisdom Tree now offer funds based on “fundamentally weighted indexes,” which use factors other than traditional market capitalization to determine the balance of their holdings. Bogle and others in his camp insist those new variations aren’t indexing—that by using factors other than market capitalization, the new funds don’t simply aim to replicate the market but are making more active bets in an attempt to produce outsized returns.
The lasting legacy of the first index mutual fund will be determined, but it’s clear that index funds are here to stay. “It was a brilliant idea,” says Arnott. “It’s an idea that has stood the test of time.”
