|The First Index Mutual Fund: A History of Vanguard Index Trust and the Vanguard Index Strategy|
John C. Bogle, Founder and Chairman of the Board, The Vanguard Group
In April 1995, just two years ago, Vanguard published a booklet that we had the temerity to title "The Triumph of Indexing." The booklet described the whys and wherefore of the remarkable success of the concept of indexing, as manifested in the investment performance of Vanguard Index Trustthe first index mutual fundand the development of the Vanguard family of index funds. It included the Chairman's Letters I had written for the 1994 Annual Reports of Vanguard's six index funds, then composed of 21 separate portfolios14 portfolios of various classes of U.S. stocks, international stocks, high-grade bonds, and balanced (stock/bond) investments, and seven portfolios focused on tax-managed or life-strategy (asset allocation) goals. By then, total assets of the Vanguard index funds had reached $18 billion, a remarkable growth from $11 million when we formed the first (Index 500) portfolio of Vanguard Index Trust in 1975.
In the introduction, I noted the remarkable success of index investment strategies over the long term, even as I disclaimed the notion that the recent performance of the Standard & Poor's 500® Composite Stock Price Indexoutpacing more than 85% of all actively managed equity mutual funds during the previous three yearswas either sustainable or repeatable. Nonetheless, I looked forward to accelerating growth for indexing as growing numbers of investors came to recognize that "the index fund is the proverbial better mousetrap a very efficient and productive means of investing in the securities markets providing extraordinarily broad diversification at extraordinarily low cost."
And accelerating growth, as it turned out, was just what came to pass. In the subsequent two years, Vanguard index assets have increased more than fourfold to a total now approaching $100 billion, including nearly $50 billion in the original 500 Portfolio. Indeed, standing alone, without counting the other $200 billion of "conventional" fund assets now managed by Vanguard, the Vanguard index funds would rank as the seventh largest complex in the entire mutual fund industry. What is more, our original concept, having met with such a fine reception from investors, is finally (and, I suppose, inevitably) being copied by many other fund groups, albeit neither with much enthusiasm nor with particularly attractive operating cost levels (other than through fee waivers that are but temporary) for investors. Be that as it may, however, we have come a long way since "Bogle's folly"a phrase I heard all too often from the late 1970s through the early 1990sfirst saw the light of day in 1975.
In an ideal world, the basis for the growth of index mutual funds would have been the gradual, if grudging, acceptance of the simple theory that underlies index investing: Investors as a group cannot outperform the market, because they are the market. And from that theory flows the reality: Investors as a group must underperform the market, because the costs of participationlargely operating expenses, advisory fees, and portfolio transaction costsconstitute a direct deduction from the market's return. Unlike actively managed funds, an index fund pays no advisory fees and limits portfolio turnover, thus holding these costs to minimal levels. And therein lies its advantage. That, essentially, is all you need to know to understand why index funds must provide superior long-term returns.
This self-evident reality, of course, wouldn't matter if experienced professional money managers were able to take advantage of tyros and amateurs. But in highly efficient markets, that doesn't happen. It doesn't happen because it is the professionals who set the prices that are paid by expert and novice alike. And the record is clear that most major financial markets are indeed highly efficient. The body of evidencesome would say brute evidenceis so abundant as to defy substantive rebuttal. The facts are: (a) most professional managers fail to outpace appropriate market indexes, and (b) those who do so rarely repeat in the future their success in the past.
Alas, these compelling propositions account for but a fraction of the recent growth of index funds. Rather, the extraordinarily favorable performance of the S&P 500 Index fundsperformance we disclaimed in "The Triumph of Indexing" early in 1995has not only continued, it has gotten even better during the remainder of 1995, in 1996, and so far in 1997. Sorry to say, index funds are "a hot product"The Wall Street Journal described Vanguard's 500 Portfolio as the "industry darling"and a significant portion of index fund asset growth appears to be coming from short-term investors who are mutual fund traders seeking quick returns, rather than long-term investors persuaded by the simple theory and the remarkable opportunity for the optimal long-term returns that indexing offers to investors who "stay the course."
But, as this history of the first index fundthe 500 Portfolio of Vanguard Index Trust (initially operating under the name First Index Investment Trust)recounts, the first 23 years have had many ups and downs, many challenges and many opportunities. Today, index funds are changing the way investors look at mutual fundsfocusing more than ever on the critical issues of cost and diversification. Even if today proves to be, as well it might, a momentary peak in popularity for the remarkably popular and successful index funds based on the S&P 500 Index, I believe the fundamentals of low-cost indexing are so strong as to prevail over the long pull. Having survived early defeat, as I note at the end of this story, the index fund can also survive victory.
Nearly six years ago, on January 15, 1992, at a speech for the Newcomen Society entitled "Vanguard's First Century," I reflected on the role of indexing in the mutual fund field. At that time, the Vanguard Index Trust 500 Portfolio had risen to become the seventh largest of all U.S. equity funds. I predicted that "market indexing will come into its own as a major force and that Vanguard will at long last confront some competition." Surely that prediction has now been justified.
I also predicted that "by the turn of the twentieth century, our 500 Portfolio will be the largest equity mutual fund in the world." Now that "the first index mutual fund" is the second largest of all equity funds, and rapidly gaining ground on the leader, that prediction doesn't seem quite so far-fetched.
I believe it will come to pass, on schedule.
Here is what happened and how it happened.*
I suppose the beginning of the first index mutual fund goes back to 1949. When I was a junior at Princeton University looking for an idea for my senior thesis, I sought a topic that literally no one had ever written about in a serious academic paper. I stumbled upon an article in Fortune magazine (December 1949) entitled "Big Money in Boston." It was the first time I had ever thought about the mutual fund industry. When I read that "mutual funds may look like pretty small change," but constituted a "rapidly expanding and somewhat contentious industry" that could be of "great potential significance to U.S. business," I knew I had found my topic.
After a year-and-a-half of research and writing this thesis, prepared by a callow and idealistic young scholarship student working his way through a great University, I concluded with several main themes, including suggesting that the industry's future growth could be maximized by a "reduction of sales loads and management fees"; that "fund investment objectives must be stated explicitly"; that mutual funds should avoid creating "the expectations of miracles from management"; and (based on the evidence I had ascertained) should "make no claim for superiority over the market averages." Others have interpreted these thoughts as a precursor of my later interest in matching the market with an index fund. Honestly, I don't know whether they were or not. Today, nonetheless, if I had to name the moment when the seed was planted that germinated into the presentation of the first index mutual fund to the Vanguard Board in 1975, that would be it.
The basic ideas go back a few years earlier. In 19691971, Wells Fargo Bank had worked from academic models to develop the principles and techniques leading to index investing. John A. McQuown and William L. Fouse pioneered the effort, which led to the construction of a $6 million index account for the pension fund of Samsonite Corporation. With a strategy based on an equal-weighted index of New York Stock Exchange equities, its execution was described as "a nightmare." The strategy was abandoned in 1976, replaced with a market-weighted strategy using the Standard & Poor's 500 Composite Stock Price Index. The first such models were accounts run by Wells Fargo for its own pension fund and for Illinois Bell.
In 1971, Batterymarch Financial Management of Boston independently decided to pursue the idea of index investing. The developers were Jeremy Grantham and Dean LeBaron, two of the founders of the firm. Grantham described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. For its efforts, Batterymarch won the prize for the "Dubious Achievement Award" from Pensions & Investments magazine in 1972.** It was two years later, in December 1974, when the firm finally attracted its first client.
By the time American National Bank in Chicago created a common trust fund modeled on the S&P 500 Index in 1974 (requiring a minimum investment of $100,000), the idea had begun to spread from academiaand these three firms that were the first professional believersto a public forum.
Gradually, the press began to comment on index investing. A cri de coeur calling for index funds to be formed came from each of several intelligent and farsighted observers.*** I still have those articles that I read nearly 23 years ago; they read just as well today.
The first article was "Challenge to Judgment," by Paul A. Samuelson, Professor of Finance at Massachusetts Institute of Technology. In The Journal of Portfolio Management (Fall 1974), he pleaded "that, at the least, some large foundation set up an in-house portfolio that tracks the S&P 500 Indexif only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess. Perhaps CREF (College Retirement Equities Fund) can be induced to set up a pilot-plant operation of an unmanaged diversified fund, but I would not bet on it. The American Economic Association might contemplate setting up for its members a no-load, no-management-fee, virtually no-transaction-turnover fund" (noting, however, the perhaps insurmountable difficulty that "there may be less supernumerary wealth to be found among 20,000 economists than among 20,000 chiropractors").
Dr. Samuelson concluded his "challenge to judgment" by explicitly calling for those who disagreed that a passive index would outperform most active managers to dispose of "that uncomfortable brute fact (that it is virtually impossible for academics with access to public records to identify any consistently excellent performers) in the only way that any fact is disposed ofby producing brute evidence to the contrary." There is no record that anyone tried to produce such brute evidence, nor is it likely that it could have been produced. But Dr. Samuelson had laid down an implicit challenge for somebody, somewhere to start an index fund.
A year later, Charles D. Ellis, President of Greenwich Associates, wrote a seminal article entitled "The Loser's Game" in The Financial Analysts Journal for July/August 1975. Ellis quickly offered a provocative and bold statement: "The investment management business is built upon a simple and basic belief: Professional managers can beat the market. That premise appears to be false." He pointed out that over the prior decade, 85% of institutional investors had underperformed the return of the S&P 500 Index, largely because "money management has become a Loser's Game. Institutional investors have become, and will continue to be, the dominant feature of their own environment causing the transformation that took money management from a Winner's Game to a Loser's Game. The ultimate outcome is determined by who can lose the fewest points, not who can win them." He went on to note that "gambling in a casino where the house takes 20% of every pot is obviously a Loser's Game."
Finally, Ellis went to the underlying economics of the matter: If equities provide an average return of 9% a year, and a manager generates 30% portfolio turnover at a cost of 3% of the principal value on both the sales and the reinvestment of the proceeds (a reduction in return equal to 1.8% of assets per year) and charges management and custody fees equal to 0.2% (low!), the active manager incurs costs of 2%. Therefore, he must achieve an annual return of +11% before these coststhat is, 22% above the market's returnjust to equal the gross market return. (That 2% aggregate cost remains pretty much the samealthough of a somewhat different compositionfor mutual funds in 1997, 22 years later.) While Ellis did not call for the formation of an index fund, he did ask: "Does the index necessarily lead to an entirely passive index portfolio?" He answered, "No, it doesn't necessarily lead in that direction. Not quite. But if you can't beat the market, you should certainly consider joining it. An index fund is one way." In the real world, of course, few managers indeed have consistently been able to add more than those two percentage points of annual return necessary merely to match the index, and even those few have been exceptionally difficult to identify in advance.
The third article, by Associate Editor A.F. Ehrbar, appeared in Fortune, the magazine that in 1949 had provided me with my original inspiration to write about mutual funds. In July 1975, in an article entitled "Some Kinds of Mutual Funds Make Sense," Ehrbar concluded some things that seem pretty obvious today: "While funds cannot consistently outperform the market, they can consistently underperform it by generating excessive research costs (i.e., management fees) and trading costs. It is clear that prospective buyers of mutual funds should look over the costs before making any decisions." He concluded that "funds actually do worse than the market." He had little hope that the mutual fund industry would rush to fill the gap created by the new view that cost is the principal reason that investors as a group are unable to outpace the market index.
Ehrbar despaired about the remote likelihood that an index mutual fund would be created very soon, noting that "there has not been much pioneering lately. While the mutual-fund industry has not provided an index fund, the American Bank of Chicago has put together a common trust fund that aims to match the performance of the S&P 500 Index." (He failed to note that, with an annual fee of 0.8%, it could not possibly do so.) But he described the best alternative for mutual fund investors: "a no-load mutual fund with low expenses and management fees, about the same degree of risk as the market as a whole, and a policy of always being fully invested." He could not have realized that he had described, with some considerable accuracy, the first index mutual fund, soon to be formed. But that is exactly what he had done.
Confronted with those three articles, I couldn't stand it any longer. It now seemed clear that the newly formed Vanguard Group (then only a few months old) ought to be "in the vanguard" of this new logical concept, so strongly supported by data on past fund performance, so well known in academia but acknowledged by few in the industry. It was the opportunity of a lifetime: to at once prove that the basic principles enunciated in the articles could be put into practice and work effectively, and to mark this upstart of a firm as a pioneer in a new wave of industry development. With luck and hard work, the idea that began to germinate in my mind in 1949 could finally become a reality.
*Based on my Princeton senior thesis, presentations to the Vanguard Board of Directors, extensive notes taken as the events occurred, 22 consecutive Chairman's Letters in Vanguard Index Trust Annual Reports, and my speeches over the same period.
**A fine history of the Wells Fargo effort is presented in Peter Bernstein's Capital Ideas (Macmillan, Inc., 1992). The Batterymarch story is told in Program Trading (J.K. Lasser Institute, 1987), by Jeffrey D. Miller.
***I should note that one of the earliest calls for indexing came from a book that I did not read until some years later: A Random Walk Down Wall Street, by Princeton University Professor Burton S. Malkiel (W.W. Norton, 1973). Dr. Malkiel suggested "A New Investment Instrument: a no-load, minimum-management-fee mutual fund that simply buys the hundreds of stocks making up the market averages and does no trading (of securities). Fund spokesmen are quick to point out, 'you can't buy the averages.' It's about time the public could." He urged that the New York Stock Exchange sponsor such a fund and run it on a nonprofit basis, but if it "is unwilling to do it, I hope some other institution will." In 1977, four years after he wrote those words, he joined the Board of Directors of First Index Investment Trust and the other Vanguard funds, positions in which he has served with distinction to this day.
The Introduction of the First Index Fund
When Vanguard was formed, it represented a unique departure from the typical industry form of organizationa privately (or publicly) owned mutual fund management company, in which the profits from fees paid by fund shareholders were garnered by the individuals owning the investment managerto a "mutual" type organization in which the fund shareholders owned the manager, with those profits reverting to them. The Vanguard Group was owned by the funds it administered. It would operate on an at-cost basis, the better to put the shareholder in the driver's seat (rather than reposing in the back seat, with the management company driving the car for a fee). Such a structure, we reasoned, would enable Vanguard to deliver extremely low operating and management costs to shareholders. We said "costs matter" then, and we have repeated it ever since.
Vanguard began operations on May 1, 1975, with a limited charter: to direct the day-to-day administrative, financial, and legal operationsbut neither the investment management nor the marketing activitiesof what had been previously known as the Wellington Group of Funds. (Responsibility for those two activities would remain with Wellington Management Company.) We were a tiny enterprise, but we had great visions of the future, and we wanted to do everything we could within our narrow mandate. We concluded that we had a remarkable opportunity to run an unmanaged, low-cost index fund and to have the market to ourselves for at least a few years. No one else wanted to start a low-cost (indeed, "at-cost") mutual fund. After all, a sponsor's objective in forming a mutual fund is to increase assets under management, thereby increasing the advisory fees and thus the profits the firm earns. For better or worse in the fund business, that is "the American Way."
There were but three persons on our tiny staffin essence, our entire strategic teamin a position to develop the investment concepts and the marketing plan for the index fund: myself, James S. Riepe (a truly remarkable young man whose promise in 1975 has been realized; today he is one of the most highly regarded leaders in the mutual fund industry, a managing director of T. Rowe Price and former Chairman of the Investment Company Institute), and a young Princeton graduate and Wharton School MBA, Jan M. Twardowski (now President of Frank Russell Securities Company), who did the awesome statistical work required for us to make our case with completeness, accuracy, and professionalism.
As the summer of 1975 began, the three of us enthusiastically set to work to make the case for an index fund, making the formal proposal to the Directors at the Board meeting on September 18, 1975. At the meeting, most of the discussion focused on whether this unique venture would be within the mandate that precluded our new company from engaging in investment advisory or marketing servicesa mandate that had been won only after a considerable internal struggle. But we were able to persuade the Board that no advice would be involved and that a public underwriting could be handled by an outside syndicate of brokerage firms. The Directors accepted this tenuous logic and approved the idea. The Declaration of Trust for First Index Investment Trust was filed on December 31, 1975.
In our final proposal to the Directors, in April 1976, we nervously prepared a draft prospectus. I sent the Board the articles referred to above and projected the costs of managing an index fund to be 0.3% per year in operating expenses and 0.2% per year in transaction costs. Since fund annual costs at that time appeared to be about 2.0%, I concluded that an index fund should reasonably be expected to provide an annual return of +1.5% above a managed fund.
Ever vigorously selling the idea, we also presented a table showing that $1 million invested at an assumed market return of 10% would be worth $17.5 million after 30 years, while a similar investment at 8.5% (using the 1.5% cost differential) would have been worth but $11.5 million. The cost saving resulted, I noted, in a $6 million payoff that was a mere six times the original amount of the initial investment. (To this very day, I use that example in my work at Vanguard.) "Great rewards grow from small differences in cost" was my simple thesis. I reinforced that concept with the historical record, showing that the average annual return of all mutual funds for the period 19451975 had been +9.7%, compared to +11.3% for the S&P 500 Index. The difference of +1.6%actually, as it happens, slightly greater than the +1.5% illustrated in my compound interest tablerepresents, to this day, a reasonable, if conservative, approximation of the long-term advantage of an index fund.
The Board recognized that an index-style mutual fund would break new ground. Unlike a pension account or pooled trust fund, it would have to deal with daily cash flows and the costs of handling thousandsperhaps hundreds of thousandsof shareholder accounts. Our initial plan described how we proposed to minimize commission costs on portfolio transactions and develop fund operational efficiencies that would not defeat our ability to closely match the index.
After getting our responses to the questions they raised over the next few months, the Directors in May 1976 approved the filing with the Securities and Exchange Commission of a prospectus and offering statement for First Index Investment Trust. (The name we chose withstood challenge from the Commission staff and from a number of adversaries.) Now it was my job to find some way Vanguardthis new "at-cost" enterprisecould raise the capital to start an index fund without our spending any money. (We couldn't afford to!) Our objective, I brashly wrote to the Board, "will be to underwrite an index fund in the $50 million to $150 million range."
The Underwriting of the First Index Fund: 1976
In those early days of our history, the Vanguard funds were "load funds," sold exclusively through brokers. Sales of mutual fund shares were hard to come by following a near-50% drop in stock prices in 19731974. We needed a "one shot" underwriting so that the new fund had the critical mass of assets needed to own hundreds of stocks. So we immediately set to work trying to enlist a top group of national brokers, including Bache Halsey Stuart (now Prudential Securities), Paine Webber Jackson & Curtis, and Reynolds Securities, to manage a public offering. After a fair amount of persuasion by us, they all came aboard, but conditioned their agreement on our persuading a fourth major firm to join them. That firm turned out to be Dean Witter & Company, which became lead manager. We had enlisted the four strongest mutual fund brokers on Wall Street. And at Dean Witter, I found a real champion for the idea. Roger Wood was that man. He was an executive in Dean Witter's Initial Public Offering group. He believed in the Trust and firmly assumed leadership of the underwriting.
As we assembled the underwriting group, our confidence that we would enjoy a successful initial offering soared when Fortune magazine's June edition appeared. A banner headline announced "Index FundsAn Idea Whose Time Is Coming," followed by a remarkable six-solid-page article by the persistent editor A.F. Ehrbar. He announced that "index funds now threaten to reshape the entire world of professional money management." Focusing entirely on pension funds, he wrote that "their present management is terrible. Instead of doing as well as the market averages, the corporate executives charged with the responsibility for pension funds have turned the funds over to a group of experts who systematically do worse"even, he added, "before fees are deducted." Ehrbar then buttressed his position with a formidable stream of rigorous data and a detailed exposition of index theory, and set forth and then rebutted each possible objection. It was a powerful elixir for Jim Riepe, Jan Twardowski, and me.
It may not have been a turning point, but it gave us the strength we needed to carry on.*
Jim Riepe and I participated in "road shows" in a dozen cities around the country, but the brokerage-firm registered representatives (today, account executives) did not seem particularly taken with the idea of a fund that said, in essence, that their professionselecting well-managed funds for their clientswas "a loser's game." Nonetheless, our underwriting group was able to raise enough money to provide the seed capital we needed. At the closing of the public offering, we had raised $11.4 milliona far cry from our initial objective of $150 million, but enough to get the fund started. First Index Investment Trust began operations on August 31, 1976. From that modest base its assets would grow at a remarkably steady annual compound rate of 53% during the next two decades, taking assets to $42 billion on June 30, 1997.
Now such a fund lay in prospect. "Sooner than I dared expect," he wrote, "my explicit prayer has been answered. There is coming to market, I see from a crisp new prospectus, something called the First Index Investment Trust." He conceded that the fund met only five of his six requirements: (1) availability for investors of modest means; (2) proposing to match the broad-based S&P 500 Index; (3) carrying an extremely small annual expense charge of only 0.20%; (4) offering extremely low portfolio turnover; and (5) "best of all, giving the broadest diversification needed to maximize mean return with minimum portfolio variance and volatility." His sixth requirementthat it be a no-load fundhad not been met, but, he graciously conceded, "a professor's prayers are rarely answered in full."
As it was to happen, Dr. Samuelson's final prayer would be answered just six months later. But until then, given our obvious need to enlist broker support for an underwriting, the Trust carried an initial sales charge (low by mutual fund standards in those days6% on smaller investments, tapered down to 1% on investments of $1 million or more). However, Vanguard was soon to change its distribution strategy. In February 1977, after an extremely contentious Board meeting at which the day was carried by a close vote of 8 to 5, the funds in The Vanguard Group, after nearly a half-century of participation in a dealer-distribution system operated by Wellington Management Company, terminated Wellington's contract and eliminated all sales charges. The Directors of First Index Investment Trust and the other Vanguard funds had overturned their initial ban on Vanguard's providing distribution services and made an unprecedented conversion to a "no-load" distribution system.
But there remained a multitude of strident critics of indexing. They were well described by Rex Sinquefield of American National Bank, an early advocate of the concept. Writing in Pensions & Investments he said: "As talk of market (i.e., index) funds moves from the discussion of debate, the exchange is often enlivened but seldom enlightened. Critics of these funds have suggested that market funds are a 'cop-out' and a search for mediocrity. Some have said they are downright un-American. Few, if any, investment concepts have been the object of so much scornful ridicule. The vitriol and paranoia permeating so much of the criticism reveals a profound misconception of the role that market funds should play in institutional portfolios."
When Sinquefield wrote those words in 1975, we had not yet filed our funddesigned for individual investorsand when we did, in mid-1976, the criticism was hardly muted. It was described as "Bogle's folly" more than once. Fidelity Chairman Edward C. Johnson III doubted Fidelity would soon follow Vanguard's lead. "I can't believe," he told the press, "that the great mass of investors are [sic] going to be satisfied with just receiving average returns. The name of the game is to be the best."
Another competitor put out a flyer asking rhetorically, "Who wants to be operated on by an average surgeon, be advised by an average lawyer, or be an average registered representative, or do anything no better or worse than average?" Pointing out that the word "average" meant "mediocre," it continued, "we don't think that describes what most people want from their professional managers." The flyer, of course, failed to acknowledge that few mutual funds had been able to achieve "average market returns." (As a group, in fact, they were falling short by 1.6% a year.) The fund manager struck hard at the concept: "We are going on record now because of the wave of publicity about index fundsfunds that, by their charter, need to do no better than the average. As professionals, we reject the thought of settling for the averages. Whatever road other fund managers may take, we are going to continue to strive for excellence." (For the record, this fund had consistently lagged the index before, and has maintained this unimpressive standard ever after.) The flyer concluded with an appeal intended to be inspirational: "No one came up with a handful of dust when he reached for the stars." Clearly, as it was to turn out, most investors were to continue to do just that!
The expected reaction to any new ideathe electric lightbulb, the tank, the telephone, the airplane, to mention just a fewis that it won't work: skepticism about the idea, condemnation upon the formation, attack when the idea becomes reality. Given the radical shortfall from our optimistic $150 million target in the underwriting, we were less than ecstatic about the final figure. But, Jan, Jim, and I were indeed ecstatic at the critical fact: We had our index fund! We had $11 million, and we promptly invested it in the stocks in the S&P 500 Index.
The first index fund now existed. By December 31, 1976, assets had grown to $14 millionranking the fund #152 in assets among 211 equity funds.
*Incidentally, reread today, 22 years later, the Ehrbar article still carries a freshness that suggests it had just been written. However, the full realization of the threat of indexing to "reshape the entire world of money management" still remains on the horizon.
The Early Development of the First Index Fund: 19771982
We had hoped to immediately invest in all of the stocks in the S&P 500 Index in their exact proportions. However, given our limited assets and the transaction costs that would have been involved in buying all 500 stocks, the initial portfolio included just 280 stocksthe 200 largest stocks (representing almost 80% of the weight of the Index) plus 80 stocks selected by various optimization models to match the profile of the remaining 220 stocks in the Index, using industry groups, market capitalizations, price/earnings ratios, and the like. Jan Twardowski, designated as the fund's first portfolio manager, did an inspired job of running it. Under his direction, the successful tracking of the Index return that the fund has maintained to this day began, even with a marginally under-diversified portfolio and the significant transaction costs involved in those ancient days when commissionsnotably on smaller lotswere much higher than they are today, and when there was no computer technology to facilitate the optimization process.
But we were off and running, and that was all that mattered. In the Trust's first Annual Report, for the "stub" year 1976, issued on January 30, 1977, we could proudly say that "First Index Investment Trust is the first and only investment company that offers an index-matching account responding to the clear statistical evidence that, for the professional and amateur investor alike, matching the Standard & Poor's 500 Index has been a tremendous challenge. We see growing markets for the Trust, as increasing thousands of investors come to utilize the index fund for the 'core' of their common stock investments." (In mid-1997, 20 years later, I cannot help reflecting that none of us could have ever imagined the substantial uptrend in stock prices that would follow, to say nothing of the continuous growth in the assets of our then-tiny index fund baby.)
The Trust's disappointing initial reception was followed by an equally disappointing ongoing acceptance in the marketplace. Despite (or, more likely, because of) the fact that First Index Investment Trust had eliminated sales commissions in February 1977, any sustained inflow of investor capital would have to await some seasoning and some "proof of the pudding" in the fund's performance. In mid-1977, with the Trust's assets languishing at the $17 million level, I sensed an opportunity to increase them substantially. Among the other mutual funds Vanguard was administering was Exeter Fund, an exchange fund (owned by investors who had exchanged low-cost securities for a diversified portfolio), with assets of $58 million. It could not offer new shares for sale and would ultimately have to be merged into another fund. In September, I presented a recommendation to merge it into First Index. After a heated debate, with Wellington Management urging a merger into Windsor Fund, the Board approved my proposal. The Trust's assets more than quadrupled, to $75 million. And at last it had the resources to own all of the 500 stocks in the Index.
Performance languished too. After performing so sensationally in 19721976, outpacing nearly 70% of all equity funds (see Exhibit II), the Index went into a disappointing spell. It outpaced only about one-fourth of the funds during 19771979. (This sort of reversal in form, which seems to plague all new fund concepts, is hardly surprising.) But we were about to move into a new decade, in which the Index would begin by outperforming nearly one-half of all traditionally managed equity mutual funds in 19801982. Far better days lay on the horizon, but they were not yet visible.
Index Growth Continues: 19831986
A boom in the stock market began in late 1982a boom, indeed, that has continued for 15 years, almost without interruption to this day. Vanguard Index Trust (the name was changed from First Index Investment Trust in March 1980) participated nicely, and the Trust's record was excellent compared with that of managed funds, outperforming nearly three-quarters of all equity funds during 19831986.
During this period, the index fund at last had started to catch the fancy of investors. Wells Fargo started the second index mutual fund (Stagecoach Corporate Stock Fund) in 1984. But burdened as it was with an expense ratio of almost 1% a year, it has never succeeded in the marketplace. (At that cost level, it was an oxymoron; it would inevitably fall far short of the performance of the very index it was designed to emulate.*) In 1985, two more index funds were formed, offered to institutions rather than individual investors. And while nine new index funds were formed in 1986, they were an odd bunch. Two invested in small-company stocks (in Japan and in the United Kingdom) and no independent indexes existed for them. (In fact, these were quantitatively managed sector funds, and these sectors have since provided rather shabby returns to investors.)
The major equity index offering of 1986 was Colonial Index Trust, which carried a sales load of 4.75%. In effect, the public was being offered an index fund that began "behind the eightball"the amount of the initial sales commissionand, due to an annual expense ratio of about 1.50%, would fall further behind the eightball with each passing year. (The marketplace proved discriminating, and the fund drew limited investor assets, putting itself out of business in 1993.)
Despite these harbingers of success, indexing remained a tiny portion of equity mutual fund assetsless than ½% of the total at year-end. There were much stronger signs of life in the private pension fund arena, where indexing had attracted nearly 15% of assets. So the uptrend was taking shape. As 1986 came to a close, another important step forward for indexing took place: the formation of the first bond index fund for individual investors. (A bond index fund for institutional investors had been started earlier in the year.) There was no question in my mind that bond indèx funds would come to meet a major need in the marketplace, because most bond mutual funds were grossly overpriced, often carrying both high expenses and excessive sales charges. A low-cost, no-load index fund seemed certain to fill some of that void.
With the formation of Vanguard Bond Market Fund, Vanguard was again the pioneer. (The SEC would not permit the use of the name "Vanguard Bond Index Fund," since the Commission staff could not accept the notion that an index fund could own a relatively small number of individual bonds and hope to closely replicate the performance of an index that included 4,000 bonds.) Vanguard had been laying the groundwork for a bond index fund during much of 1986, but the final inspirationthis is truecame when Forbes magazine, writing about second-rate returns and high costs of most fixed-income mutual funds, expressed a crying need for a low-cost bond index fund. The magazine plaintively asked, "Vanguard, where are you when we need you?" Thus, yet another cri de coeuran echo of the pleas of Paul Samuelson and Charles Ellisprovided the final impetus. Once again, we responded. In the ensuing years, our bond index fund was to prove both an artistic and commercial success, admirably tracking the Lehman Brothers® Aggregate Bond Index and becoming one of the ten largest bond mutual funds by the end of its first decade.
As 1986 drew to a close, the assets of the first stock index fund had quintupled in only four years, approaching the $500 million milestoneranking #71 among 423 equity funds.
*That high cost was recently justified by a Wells Fargo spokesperson as "so we can make a lot of money. The fund is a cash cow."
The March to the $1 Billion Milestone and Beyond: 19871990
During the 19871990 period, the conceptual framework of the Vanguard index fund "family" was established, and the implementation of the strategy began. Early in 1987, we decided that an index fund modeled on the S&P 500 Index, good as it was, was in some sense not good enough. To be sure, it provided a means to match approximately 75% of the U.S. stock market (the portion of the market represented by the stocks in the S&P 500 Index at that time). It would thus have a powerful tendency to match, with near perfection, the return of the entire stock market over the long term. But it did not include stocks with medium-size and small market capitalizations. There were, however, good theoretical and practical reasons to have an index fund that owned such equities, so as to offer investors complete diversification in the form of ownership participation in the entire U.S. stock market.
At first, we considered converting the 500 Portfolio into such an all-market portfolio, but finally rejected that idea and decided to form an "Extended Market" portfolio covering the "non-500" portion of the market by replicating the Wilshire 4500 Equity Index. Owning all 4,500 issues would have been prohibitively expensive, so we decided to own the 2,000 largest stocks, and use optimization models based on industry diversification, relative price/earnings ratios, etc., to select 800 additional issues. The Extended Market Portfolio was designed and registered with the SEC in August 1987. It would be the third member of the Vanguard index fund family, a burgeoning group that would number 26 in mid-1997. (See Exhibit III.)
Vanguard Small Capitalization Stock Fund had been run as an actively managed fund by an external investment adviser. After a long series of fine years, the Fund had provided distinctly inferior results during 19851988. In 1989, we impulsively terminated the advisory contract, converting it into a small-capitalization index fund. The SmallCap Portfolio of Vanguard Index Trust was underway, starting with the existing asset base of $30 million. It was to provide fairly consistent competitive returns relative to other blended growth/value small-cap funds, and, under Gus Sauter's direction, it did a remarkable job of matching the Russell 2000® Index of small stocks. The SmallCap Portfolio had become the sixth Vanguard index fund.
During 1990, the growth in the Vanguard index family accelerated again. We considered an international fund modeled on the Morgan Stanley® Capital International Europe, Australasia, Far East (EAFE) stock index. But we were concerned about the substantial risk of a bubble in the Japanese stock market at that time.
In June, we came to grips with the dilemma by starting two international fundsone indexed to the European portion of the EAFE Index and the other to the Pacific portion. Fortuitous or smart, our previous evaluation of the Japanese market proved correct, and the decline that began in 1989 has continued to the present day. Nonetheless, we have tracked both indexes with extraordinary precision despite the substantial portfolio turnover costs, stamp taxes, and limited liquidity (relative to the U.S.) in many foreign markets.
In July, we took another step designed to keep us fully competitive in the still-tiny index component of the marketplace (only about 1% of all stock fund assets). We formed Vanguard Institutional Index Fund, modeled on the S&P 500 Index and designed for institutions with substantial assets. To achieve the administrative economies involved, we set a minimum initial investment of $10 million per account. We were quickly able to offer the Fund at an annual expense ratio of just 0.07%, compared to 0.20% for our basic 500 Portfolio. (The expense ratio of the average stock fund was then about 1.30%.) At that expense level, we could be a strong competitor for institutional accounts in the $10$75 million range. That new fundlittle noted by the press or by mutual fund industry observershas distinguished itself over the ensuing years. Today its assets are $16 billion. Thanks to Gus Sauter's skills, it has succeeded in precisely matching the total return of the theoretical (and cost-free) Index itself, despite the Fund's necessary operating and transaction costs.
1990 also saw the first stirrings of stronger competition entering the index field. Fidelity, despite its commitment to aggressive active management, started two stock index funds, both modeled on the S&P 500 Index, and a U.S. bond index fund. However, Fidelity's heart did not seem to be in those introductions. One stock index fund was part of its then-new Spartan Fund series, designed for wealthy individuals and requiring a $25,000 minimum initial investment. The two other funds were institutional funds, requiring minimum investments of $1 million.
As 1990 ended, 43 index funds were in operation, but indexing was hardly a household concept. Many funds were designed solely for institutional investors. Some were not truly index funds at all, simply operating in discrete market segments (e.g., Japanese small company value stocks). Others were quantitative funds, run by computer programs making individual stock selections designed to resemble the industry composition and risk profile of an index, but with the goal of enhancing its returns.
Vanguard had started the first such quantitative fund, Vanguard Quantitative Portfolios, late in 1986. In the decade-plus since then, however, the fund has found it a tough challenge to significantly outpace the market. It has outpaced the Vanguard 500 Portfolio by a modest +0.2% a year (+15.2% versus +15.0%). But the average traditionally managed competitor proved a pushover, and during its ten-year lifetime Quantitative (now known as Vanguard Growth and Income Portfolio) has outpaced about 90% of all growth and income funds.
The S&P 500 Index again outpaced three-quarters of all equity mutual funds in 19871990, continuing its impressive relative performance in 19831986. Indexing continued to make inroads in the institutional arena, increasing from 15% to 20% of pension assets. And in the mutual fund field, its tiny penetration finally showed signs of life, leaping from ½% to 2½% of equity fund assets. With assets of $2 billion as the period ended, the Vanguard 500 Portfolio remained the largest index fund, and now ranked #14 in size among 663 equity mutual funds.
The Evolution of an Index Strategy: 19911993
As 1991 began, real competition in the index arena was nowhere to be found. Few competitors had entered the field, and those that did so entered at prices that gave Vanguard first call on the assets of investors seriously considering indexing. (Average expense ratios were in the 0.50% range versus 0.20% for Vanguard Index Trust.) Vanguard, meanwhile, was broadening the concept of indexing even further. We were about to make it more convenient to own the total stock market. Previously, an investor could do so only by making a joint purchase of appropriately weighted investments in the 500 Portfolio and the Extended Market Portfolio. Vanguard Total Stock Market Portfolio, with the objective of matching the Wilshire 5000® Equity Index, was born in April 1992. Vanguard Balanced Index Fund was formed a few months thereafter, based 60% on the Wilshire 5000 Equity Index and 40% on the Lehman Brothers Aggregate Bond Index. The number of index funds in the family had reached nine.
In a 1990 speech to the Financial Analysts of Philadelphia entitled "Acres of Diamonds," I described the expansion Vanguard expected in the indexing business and had the temerity to say: "The introduction of index funds focusing on growth stocks and value stocks awaits only the availability of a Growth Index and a Value Index." Sure enough, in May 1992, Standard & Poor's developed the S&P/BARRA® Growth and Value Indexes; six months later, our Index Trust Growth and Value Portfolios were launched. So, as 1992 came to a close, the Vanguard index fund family had expanded to eleven members. Still, the industry seemed unimpressed. None of the major firms joined the fray, but an additional 35 index funds (or quasi-index funds) were formed, bringing the total to 78.
The 19911993 period did not favor the S&P 500 Index, the focal point of both those who praised indexing and those who condemned it. Small-cap funds performed very well, and the large-cap S&P 500 Index outpaced only 45% of the professionally managed equity funds during those three years. We put quotes around the word "only" in our annual reports, in order to emphasize that outperforming 45% of all managed equity funds was a far cry from disaster. (For the record, the Wilshire 5000 Equity Index, a better representation of the portfolios of equity mutual funds, outperformed about 55% of all funds during the same period.) These were hardly the glory days of indexing, but they were not bad, and the funds continued steadily to gain ground.
In the mutual fund industry, the share of equity fund assets represented by index funds rose from 2½% to 3½% during 19911993a small impact to be sure, but a 40% gain. And in the pension fund area, indexing grew to claim fully 25% of assets. At the end of 1993, assets of the Vanguard index family had reached $18 billion, 14% of the assets under Vanguard's supervision. Assets of the 500 Portfolio rose fourfold, to $8.3 billion, and it ranked as the eighth largest equity fund.
The Triumph of Indexing: 19941996
As it turned out, the 19911993 period provided "the pause that refreshes" for superior index returns. Following the normal regression to the mean (before costs) that seems an eternal rule in the securities markets, index funds began to solidly outperform the active managers again. The pause had proved to provide a solid base for an upward trend to the long-term mean of above-average returns (after costs).
Although we didn't know it at the time, a halcyon era lay before us as 1994 began. While the stock market stumbled during 1994 and the average mutual fund declined, the 500 Portfolio turned in a gain of +1.3%. When the year ended, it had outpaced 78% of all equity funds. The bull market returned with a vengeance in 1995, and the S&P 500 Index provided a remarkable return of +37%, outpacing 85% of all general equity funds. In 1996, the bull market continued, and the Index (+23%) outpaced 75% of all managed equity funds. For the three years combined, 91% of the managed funds would lag an unmanaged index fund.
The expansion of Vanguard's index fund family continued apace with the creation in March 1993 of the industry's first specific-maturity bond index funds. The Long-Term Bond, Intermediate-Term Bond, and Short-Term Bond Portfolios of Vanguard Bond Index Fund were modeled after the comparable segments of the Lehman Brothers Aggregate Bond Index. They too affirmed the principle that low cost was the critical ingredient in shaping bond fund returns.
Late in 1993, yet another Vanguard index fund was on the drawing board. With determination that overcame our timidity, we decided to add an emerging markets portfolio to our International Equity Index Fund, in order to complete our entry into the international markets. Our determination was based on the long-term utility of such a portfolio; our timidity on the fact that the emerging markets had soared to what seemed speculative heights. As a result, heavy risks were evident as the year drew to a close and we formed the Portfolio. Happily, procedural and regulatory issues delayed our offering until May 1994, by which time the bubble in the emerging markets had burst. If "timing is everything," we had the fates with us in the introduction of the Emerging Markets Portfolio, our fifteenth index portfolio.
Despite our enthusiasm for and confidence in the index concept, we had been hesitant to exploit one of its major, if tacit, advantages: the tax advantage. By virtue of holding a passively managed portfolio, an index fund should tend to have very low portfolio turnover, and thus retain unrealized capital gains rather than realizing them and distributing them, subjecting shareholders to substantial taxes. The supposition proved correct. According to a comprehensive study of fund performance over 15 years by Stanford University economists John B. Shoven and Joel M. Dickson, our Vanguard index fund outpaced 92% of all equity funds on an after-tax basis, even better than its superiority over 80% of funds on a pre-tax basis. Yet, because large share redemptions could force an index fund to realize gains, we were reluctant to emphasize the benefit.
In 1993, we began the development of a new index fund concept that would optimize its potential tax advantage. We formed not one, but three, index-oriented funds that would levy a transaction fee on shareholders who redeemed within a year (2% penalty) to five years (1% penalty). The idea was to appeal to long-term investors and avoid the "hot money" of speculators. Vanguard Tax-Managed Fund included: (1) a Growth and Income Portfolio, designed to track the S&P 500 Index, but with the ability to vary slightly from the Index by selling stocks that had an unrealized loss, in order to offset capital gains that may have been realized by other sales, thus minimizing realized capital gains; (2) a Capital Appreciation Portfolio, designed to hold low-yielding stocks, using the Russell 1000® Index as a rough tracking standard, thus minimizing taxable income as well; and (3) a Balanced Portfolio, with assets divided 50/50 between the low-yielding stock portfolio and tax-exempt municipal bonds. The Tax-Managed Portfolios were introduced early in September 1994.
Just three weeks later, we began the offering of four LifeStrategy® Portfolios, each with different allocations to stocks, bonds, and short-term reserves. They were designed to invest in appropriately weighted portfolios of existing Vanguard index funds. The equity ratio targets established for the four portfolios were: Income, 20% of assets; Conservative Growth, 40%; Moderate Growth, 60%; Growth, 80%. The balance was composed of various bond index portfolios. The LifeStrategy Portfolios also utilized Vanguard Asset Allocation Fund, formed in 1988, which provided a portfolio of U.S. Treasury bonds and indexed stocks. We had selected as its investment adviser Mellon Capital Management of San Francisco, led by William Fouse. This fund combined his pioneering work in indexing and in tactical asset allocation, dating back to 1971, with our pioneering work in index mutual funds, since 1975.
Two additional Vanguard index funds were approved by the Board of Directors in late 1995. The Total International Portfolio was offered in April 1996 as a "fund of funds," a composite of our underlying European, Pacific, and Emerging Markets Portfolios. A REIT (real estate investment trust) fund, providing a low-cost way for investors to diversify into the real estate asset class, was launched in May. With our five index-based asset allocation funds and the 21 regular index funds, the Vanguard index family had grown to 26 funds.
During 19941996, the index fund concept would become firmly established in the minds of serious investors, and would gain considerable attention in the press. The relative consistency of index performance became apparent. In the 20-year history of the 500 Portfolio of Vanguard Index Trust, through 1996, Morningstar had placed the Portfolio in the first quartile among all mutual funds seven times, the second quartile five times, the third quartile seven times, and the last quartile but once (in 1977, the Portfolio's first full year of operation), a record of performance consistency matched by only a handful of equity mutual funds during those two decades.
The first five years of the 20-year period began on a negative note, when the Portfolio's return actually fell short of the average competitive mutual fund by 4.8 percentage points per year. This was likely a simple regression to the mean from the well-documented extraordinary +4.7 percentage point annual superiority of the Index itself during the previous five years. (Clearly, the 500 Portfolio should have begun either five years earlier or five years later!) In the next five years (19811986), the Portfolio posted a +3.0 percentage point annual superiority, followed by a +2.1 percentage point annual margin in the next five years, then closing with a further +2.6 percentage point annual advantage in the final five plus years. In all, the S&P 500 Index achieved a margin of superiority of +1.1 percentage points over the average equity fund (a figure that does not take into account the returns of funds that have since gone out of existencethe presumably poorer-performing funds). The S&P 500 Index also led the Portfolio by +0.40 percentage points, largely as a result of operating costs, especially in the Portfolio's formative years. (See Exhibit IV.)
As 1995 began, I wanted to let the world know unequivocally that indexing was here to stay, and we prepared a booklet entitled "The Triumph of Indexing." Using excerpts from my Chairman's Letters in the 1994 Annual Reports, I proclaimed: "Index funds have come of age," and cited former star Fidelity Magellan Fund manager Peter Lynch's 1990 statement that "the public would be better off in an index fund."
Soon after "The Triumph of Indexing" was published, a signal event occurred. Money magazine dedicated much of its August 1995 issue to the success of indexing. The cover depicted Vanguard Core Management head Gus Sauter, along with two luminous active money managers. A lead editorial by Executive Editor Tyler Mathisen embraced the index concept and called on readers to "make a complete reorientation of your expectations as an investor." He described the index fund advantages of low operating cost, low transaction costs, and low exposure to capital gains taxes as "a trio as impressive as Domingo, Pavarotti, and Carreras." The headline on the editorial generously declared: "Bogle wins: Index funds should be the core of most portfolios today," and ended with a personal salute, "So here's to you, Jack. You have a right to call it the Triumph of Indexing."
Money, like Saul on the road to Damascus, had experienced an epiphany. And so had many investors. Index assets in the Vanguard complex soared, reaching nearly $70 billion on December 31, 1996. The 500 Portfolio of Vanguard Index Trust, which on August 31, 1996, had reached the 20th anniversary of its initial public offering, soared to new heights, with assets reaching $30 billion at year-end. It was now the third-largest equity mutual fund in the world, larger than all but two of 4,000 U.S. equity funds. It would become the second-largest before January 1997 ended.
The Industry Finally Responds
Many observers thought that it was premature to declare "the triumph of indexing" in 1995. What followed thereafter made it clear thatat least through mid-1997"triumph" was not too strong a word. Continued superior index fund performance and burgeoning investor acceptance were to give us still further encouragement that the simple concepts I had described in my Princeton thesis in 1951, and the basic insights of forward-thinking financial professionals that inspired me in the mid-1970s and had ushered in the first index mutual fund, were here to stay.
The initial response of other firms in the mutual fund industry to the idea of indexing was tepid to a fault. Industry giant Fidelity Investments had poured cold water on the idea in 1976, but had finally been compelled to offer an index fund 14 years later, in 1990. Organized under the Spartan label in 1990 (with a $25,000 minimum initial investment), it had gone nowhere. Its name was changed to Fidelity U.S. Equity Index Fund in 1992, with a $3,000 minimum. Even the newly named fund was offered with little enthusiasm, however, and carried a rather high expense ratio of 0.45% per year. Fees were waived, however, for "a temporary period of time" to 0.25% in order to establish some low-cost credentials.
Dreyfus, ever the marketer and then the second-largest firm in the field, had begun the Peoples Index Fund (based on the S&P 500 Index) in 1987it carried a relatively high 0.50% annual feeand followed it with a similar fund for institutional investors in 1990, a bond market fund in 1993, and a mid-cap fund in 1995. Earlier, it had formed a series of managed index-oriented target funds run by Wilshire Associates. T. Rowe Price, another industry leader, climbed aboard the seemingly inevitable bandwagon in 1990 with an S&P 500 fund for institutions. The spate of institutional funds was a recognition that index funds were becoming almost an essential investment option in the burgeoning corporate 401(k) thrift plan market. But none of the other major fund groups tested the index fund waters. Without serious competition, Vanguard experienced a steady increase in its market share of index mutual fund assets, accounting for about 70% of the assets of index funds offered to individual investors as 1997 began.
In January 1997, the acceptance of index funds accelerated. Fidelity, for years unwilling to endorse the concept, stated its intention to offer three more index funds, bringing its total offerings to individual investors to four. The offerings, again under the Spartan (high minimum purchase) label, included a total stock market fund, an extended market fund, and an international equity fund. Each would apparently carry a relatively high expense ratio, but management fees would be temporarily capped so as to limit the expense ratio to about 0.25% annually through 1999. By mid-year, Fidelity had further reduced the temporarily low fee to 0.19%. In addition, the firm determined not to administer the funds itself, but to have Bankers Trust Company do so. The presumption is that the fee was negotiated vigorously, and is probably about 0.01%.
Merrill Lynch, long a reluctant dragon, also announced its intention to join the parade. Since an index fund should have a natural cost (including the tiny costs of handling the fund's investments, plus the substantial costs of handling the fund's operations) of only about 0.20% to be competitive, Merrill would offer it only as part of an asset management account that carries a 1.5% advisory fee. Such a fee would, of course, defeat the whole purpose of low-cost indexing. The reception of the idea by the marketplace will be interesting to witness.
The long reluctance of major mutual fund managers to form index funds doubtless comes from two major sources. First, indexing is a business in which it is very difficult for an adviser to earn profits. To state the obvious, no investment advice is needed, and none should be paid for. While the marketplace might permit a modest profit, it is hard to see how, in the long run, annual expense charges could exceed 0.25%, at least as long as Vanguard continues to set the standard at 0.20% per year (or lower0.06% is the current expense ratio of Vanguard Institutional Index Fund). Higher charges would seem to be unjustifiable to an investor with any native intelligence or for that matter with any fiduciary responsibility. Given that a generic index fundoperated at cost and without profit to its sponsoris close to a pure commodity, a higher price should not be possible in a competitive marketplace. However, the industry will doubtless struggle to match lower prices by using temporary fee waivers, with fees edging up over time, hoping that the investors won't notice. Although some investors with substantial gains might be "locked-in" when expenses rise, fee ratcheting would seem to be a risky long-run strategy.
If lack of profit potential for the adviser in the mutual fund business causes reluctance to embrace indexing, it must be recognized that mutual funds exist solely to make money for their investorsimplying minimal costsbut mutual fund management companies exist importantly, if not primarily, to make money for their advisersimplying that they should charge the highest costs that traffic (i.e., the market) will bear. The two motives obviously come in conflict. Indeed, they fly in the face of St. Luke's wisdom that "no man can serve two masters." But no matter; the industry rolls merrily along.
In addition to the infinitely small profit potential for advisers to index funds, there's the matter of professional pride. Mutual fund advisers build organizations of brilliant, attractive, well-educated MBAs (often from Harvard, Wharton, and the like) who strive to outpace the market. The fact that they have not been able to do so as a group apparently doesn't faze those who are able to do so at least once in a while. But for a firm to summon its highly paid professional money managers, security analysts, and research analysts to a meeting and tell them that they are going to be competing with an in-house index fund certainly would be a difficult bridge for many managers to cross. Indeed, when Fidelity announced its index fund expansion early in 1997, indicating it was beginning to take the subject with the seriousness it deserves, the firm reiterated the belief that its actively managed funds could once again outperform the market. It was offering index funds, it said, simply because some investors were demanding them. (Given that odd reasoning, it is fortunate for the world that most investors aren't demanding a participation in the Brooklyn Bridge.)
Nonetheless, it turns out that, in both academic theory and real-world practice, index funds have conclusively demonstrated the reality of the financial markets: All investors as a group, including a huge component of large institutions with professional managers and skilled individual investors owning carefully selected stocks, are the market. And since all investors as a group are the market, there is no way that they can outpace the market.
That elemental fact holds true before the costs of investing. After costs, the returns of all investors inevitably lag the market by the amount of the cost. These two simple syllogisms hardly defy rationality, and in the last analysis it is amazing that the principle has been resisted or misunderstood for so very long. In short, it doesn't take modern portfolio theory, or a belief in "efficient markets," or quantum mathematics to prove the index thesis. It requires no more than common sense.
Given the results achieved by active managers over the past 20 years plus the results mutual funds achieved over the prior 30 years that I illustrated for the Vanguard Directors in 1976, we now have more than a half-century of real evidence. Based on that evidence alone, it would seem inevitable that the growth of indexing will be widespread, will accelerate, and will become pervasive in the mutual fund industry, where, despite the public attention being given to index funds, only 6% of equity assets are currently indexed. (See Exhibit V below.) Among pension plans, however, in the presumably wiser institutional market, at least 25% of equity assets already are indexed.
A bit later in 1997, when the Annual Report for 1996 of Berkshire Hathaway Corporation was published, Warren E. Buffett, probably the most successful long-term investor in America, added another strong affirmation: "Seriously, costs matter. For example, equity mutual funds incur corporate expenseslargely payments to the funds' managersthat average about 100 basis points, a levy likely to cut the returns their investors earn by 10% or more over time Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."
As the implications of this elemental mathematical formula are recognized, the impact of indexing will permeate the entire mutual fund field. The average equity fund now has an expense ratio of more than 1.5% and transaction costs in the range of at least 0.5%a shortfall of two percentage points a year against the market's return. In a world where investors increasingly think long term, the implications of the magnitude of this fiscal drag on compound returns will become clear. Investors will inevitably begin to focus on index fundsnot because they performed so brilliantly in 19941996 and again in early 1997, but because their performance, over a long period of years, has consistently met a high standard of adding value. As a practical matter, the amount of that extra value is almost precisely what theory would indicate.
Will the Past Be Prologue to the Future?
Currently, too many mutual fund investors have an investment horizon limited to weeks or months. Redemptions of equity funds and exchanges among them take place with extraordinary frequency. Turnover in holdings of mutual fund shares is comparable to the turnover in individual common stocks. In important measure, the mutual fund business has become a casino, with the focus on the short term. Just as the stock market is a zero sum game (albeit one that has provided a positive bias and therefore a zero sum relative game), so the fund casino is a zero sum game, but only before the house takes its "handle" of as much as 20% of the amount earned (i.e., a cost of 2% of assets would consume 20% of a 10% return). In the short run, that may not matter, but in the long run it will. And, assuming that today's investors will begin to invest in a 401(k) plan or an IRA before they are age 25, and will be living off the fruits of their accumulations even after they reach age 75, then something like a half-century will prove to be a normal time horizon for virtually all U.S. investors.
What difference would an index fund make over 50 years? Well, let's postulate a +10% long-term annual return on stocks. (It may not be that large during the coming decade, and even a positive return over any given decade is hardly assured.) If we assume that mutual fund costs continue at their present apparent level of about 2% a year, an average mutual fund would return 8%. This 2% spread is very close to that of the past 15 years, during which the Vanguard 500 Portfolio provided a 2.2% margin of return over the average equity fund (or, more accurately, the better performers that survived the period), if higher than the 1.6% margin provided by the S&P 500 Index itself during the 30 years covered in my presentation to the Vanguard Directors in 1976. In any event, extending this compounding out in time on a $10,000 initial investment, the market (at 10%) would produce $1,170,000 after 50 years; the mutual fund (at 8%) would produce $470,000. The difference in return between the two$700,000is an unbelievable 70 times the initial stake of $10,000.
Looked at from a different perspective, our hypothetical fund investor has earned $1,170,000, donated $700,000 to the mutual fund industry, and kept the remainder of $470,000. The financial system has consumed 60% of the return, the fund investor has achieved but 40% of his earnings potential. Yet it was the investor who provided 100% of the initial capital; the industry provided none. Confronted by the issue in this way, would an intelligent investor consider this split to represent a fair shake? Merely to ask the question is to answer it: "No."
To be sure, as Coleridge reminds us, "history is but a lantern over the stern." And many changes lie in prospect during the years ahead. Some could reduce the substantial extra margin of return earned by an index fund in the past. At least four possibilities exist:
Appendix: Performance Summary
Average Annual Total Returns For Periods Ended September 30, 1997
*Performance figures since inception.
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