The Devil’s Invention

June 27, 2011

Putting numbers to this theory, the cost difference is dramatic. Vanguard was saving its index fund investors about 1.8 percent per year—the expense ratio of the Vanguard 500 portfolio was 0.2 percent versus 2.0 percent for the average equity fund (expenses plus transaction costs). To put that amount into perspective, in a market with a 10 percent annual return, an index fund might provide an annual return of 9.8 percent, while a managed fund might earn an annual return of 8.0 percent. If this happens, over 20 years, a $10,000 initial investment in an index fund would grow to $64,900, while an identical investment in a managed fund would grow to $46,600, a difference of more than $18,000 in the accumulated account value.

John BogleEven though he was deeply committed to indexing, Bogle was willing to admit that some active investment managers could add value to the fund management process. In most cases, he argued, these managers either were lucky or were among a tiny group of true investment geniuses—market wizards such as Warren Buffett, Peter Lynch, Michael Price and Vanguard's own John Neff. In general, though, Bogle maintained that trying to outperform the market was a futile exercise. "Index funds," he said, "are a result of skepticism that any given financial manager can outperform the market. How can anyone possibly pick which stock funds are going to excel over the next 10 years?" In this context, the best strategy is simply to try to match the market in gross return and count on indexing's low costs to earn a higher net return than most competitors.

All of this, of course, was heresy to traditional active fund managers, who argued that the only reason to invest in mutual funds in the first place was to try to maximize returns, not simply match the market on the way up and the way down. But eventually, despite the ridicule of active fund managers, indexing began to catch on. The Vanguard 500 Index enjoyed positive net cash flow in each year of its existence and had grown to $500 million by the end of 1986—a decade after its launch. That same year, the Colonial Group introduced an index fund, the industry's second. (It would be out of business by 1990, however, because it carried a punitive load and a high expense ratio, thus eliminating any ability to match the index.) By 1988, Fidelity and Dreyfus had followed suit with their own index fund offerings.

Initially, Bogle spoke of the index fund as "an artistic, if not a commercial, success," but that changed during the 1990s, when investors started to notice that the fund was beating most of its peers. From 1985 through the end of 1999, the Vanguard 500 earned a return of 1,204 percent, compared to the 886 percent average for the large-cap blend fund category, according to fund tracker Morningstar. Gradually, the fund's assets gathered steam, first topping the $1 billion mark in 1988 and beginning the 1990s with $1.8 billion. It then grew to $9.4 billion by 1995 and finally surged to $107 billion by the March 2000 peak, ultimately surpassing its archrival the Fidelity Magellan fund in the following month to become the largest mutual fund in the world.

Along the way, the technology for managing the "unmanaged" fund had improved dramatically. The fund's second manager, Gus Sauter, who today is Vanguard's CIO, took over the fund in 1987 and ran it through 2005. "When Gus first got here and looked at the software that was being used to manage the index funds, he said, 'You've got to be kidding me,'" says Vanguard CEO Bill McNabb. "The software was from the 1970s, a decade old. Gus came in, taught himself the old computer language, did diagnostics, and rewrote all the code in his spare time. You can see the difference in the index funds from the point Gus took over. There were two factors—one, he rewrote the software, and two, he figured out how to use [index] futures. You can look at the tracking error in the early 1980s, and when Gus came in 1987, and you see this tremendous change in how tightly the funds began to track their benchmarks."

For Bogle, an index fund modeled on the S&P 500 was only the beginning. As the Vanguard 500 fund grew in market acceptance and successfully operated at minimal cost, Bogle's confidence in the concept increased. The Standard & Poor's 500 represented roughly 70 percent of the market's capitalization. What about a portfolio that tracked the remaining 30 percent? Vanguard's Extended Market Index, formed in 1987, enabled investors to do exactly that, tracking the Wilshire 4500 Index.

Later, to simplify the process of holding both the S&P 500 Index and the Wilshire Extended Market Index, Vanguard offered the Total Stock Market Index, essentially owning the entire stock market by tracking the Wilshire 5000 Index, the most comprehensive market benchmark available. In 1989, the Small-Cap Index was introduced, using the Russell 2000 Index of small stocks, and a lower-cost 500 portfolio was designed for institutional investors with at least $10 million to invest. (Originally, most of the above index funds had slightly different names, often using the word "portfolio" instead of "index.") Today, assets in the Total Stock Market Index actually exceed those in the S&P 500 Index, and Bogle himself prefers it as the best proxy for the U.S. stock market.

In a speech before the Financial Analysts of Philadelphia in 1990, Bogle said, "The introduction of index funds focusing on growth stocks and value stocks awaits only the development of a growth index and a value index." Standard & Poor's introduced these two new indexes in May 1992, and just two months later, Vanguard launched portfolios with similar objectives. Bogle was confident that the principles of indexing would also work in world markets—perhaps work even better, since the expense ratios and port­folio transaction costs of international mutual funds were far higher than they were for U.S. funds. The Vanguard International Equity Index Fund was introduced in 1990, with European and Pacific Rim portfolios; an Emerging Markets index was added in mid-1994.


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