The Chief Cornerstone

March 01, 2006

The Chief CornerstoneComments from John C. Bogle, founder and former chief executive officer of The Vanguard Group, at the Superbowl of Indexing in Scottsdale, Arizona, on December 7, 2005.

This is an anniversary speech, for almost exactly thirty years ago, on December 31, 1975, the first index mutual fund was founded. Proudly known as "First Index Investment Trust" when it began, that original fund, now named Vanguard Index 500, is the largest mutual fund in the world.

Since that first index fund was formed all those years ago, indexing has come of age. Now part of the language of investing, "index fund" no longer needs an elaborate explanation; it has gained almost universal acceptance in the world of academe, and it has established the standard- "the hurdle rate," if you will-against which the investment performance of active managers is measured.

What is more, indexing has changed the behavior of investors. Rare is the Wall Street research report that uses those archaic terms "buy," "sell" or "hold" to define its recommendations. Today, it is "overweight," "equal weight" or " underweight" relative to a stock's capitalization in the Standard & Poor's 500 Stock Index-an index-oriented approach to investment advice. Indexing has spawned a half-trillion-dollar "enhanced index" (quantitative fund) industry, largely based on computer-driven strategies aiming to hold market risk constant while marginally outpacing the index with small, often nearly invisible, variations in the weights and composition of the index's individual stock components.

Indexing has also forced managers of mutual funds holding portfolios of large-capitalization stocks to minimize their risk of materially departing from the stock market's return, the better to stabilize cash flows from investors - essentially, therefore, setting marketing strategy. Of the 100 largest equity funds, fully three-quarters have market correlations of 0.90 or above, including one-fourth at 0.97 to 0.99. (We call these funds "closet index funds.")

Even more important, though almost never mentioned, is that indexing has been instrumental in awakening the investment world-the buyers and sellers of investment services alike-to the vital importance of costs. Intermediation costs, it turns out, are the only reliable predictors of the future relative returns of mutual funds. (No, past performance doesn't do the job.) At the same time, indexing has at long last required us to open our eyes to the failure of our financial agents to serve, first and foremost, the interests of the principals who have entrusted their hard-earned money to them.

It's fair, I think, to say that indexing has changed the way we think about investing.

The Birth Of The Index Fund

It is no secret that the first index fund, while easily conceived, had a difficult birth, and that its neo-natal years were hardly punctuated with success. In fact, without the inspiration of Nobel Laureate economist Paul Samuelson, it might have taken many more years for the creation of "First Index." In an article entitled "Challenge to Judgment," published in the Journal of Portfolio Management in the autumn of 1974, Dr. Samuelson demanded that those who did not believe that a passive index would outperform the vast majority of active managers produce "brute evidence to the contrary." He pleaded for someone, somewhere, to at least establish an in-house portfolio that tracked the S&P 500 Index.[2]

I quickly accepted the challenge, and examined the brute (or brutal!) evidence. Poring over the records of equity mutual funds from 1945 to 1975, I found that they had consistently failed to beat the market. My study convinced the directors of the newly-formed Vanguard Group to approve the formation of the index fund. When he received the First Index offering prospectus in the mail, Dr. Samuelson was elated. Writing in his Newsweek column in August 1976, he happily declared, "sooner than I dared expect, my explicit prayer has been answered."

But the applause for the new idea was, well, less than universal. The offering of that first index fund, planned for $150 million, produced proceeds of barely $11,320,000. The annual returns of the index itself, after outpacing more than 70 percent of equity funds in 1969-1975, fell to the 22nd percentile in 1977-1979, and cash flows into the new fund were minuscule. Small wonder that the fund was widely referred to as, yes, "Bogle's Folly."


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