Index fund is here to stay

Way back in 1978, in the third annual report of Vanguard IndexTrust, the first index fund, I used a quotation from Englishlexicographer Samuel Johnson to make a point: "It was the triumph ofhope over experience." With his inimitable wit, Dr. Johnson wasspeaking of a man who married for the second time; I was speaking ofa poll of pension managers taken by Institutional Investor. Just 17percent of these money management professionals, the magazinereported, had outpaced the Standard & Poor's 500 Index during theprevious decade, but fully 95 percent expected to outpace the indexin the coming decade.

In the years that followed, what we witnessed was quite thereverse: "the triumph of experience over hope." The hope of beatingthe index was dashed; the hard experience that had characterized somany professional managers before 1978 has repeated itself over andover. The index has outpaced 79 percent of all managers of equitymutual funds that survived the 20 years since then. As 1995 began, Ihad the temerity to publish a booklet titled The Triumph of Indexing,describing both the relative performance of the Standard & Poor's 500Index and the growing acceptance of index mutual finds by theinvesting public, a trend that I had awaited for so long.

The timing of the booklet, as it turned out, was auspicious.Since its publication, the word "triumph" has hardly done justice tothe colossal success that index funds have enjoyed. On theperformance front, the Standard & Poor's 500 Index, given its biastoward stocks with large market capitalizations, has outpaced astunning 96 percent of all actively managed equity funds. The morerepresentative all- market Wilshire 5000 Equity Index has outpaced 86percent of those funds, also an imposing performance. On theacceptance front, assets of index mutual funds have risen more thansixfold, from $30 billion to some $200 billion.Index mutual funds, which accounted for only 3 percent of equityfund assets in 1995, represented 6.4 percent just three years later.With estimated cash inflow of $50 billion in 1998, index fund flowswere equal to 25 percent - fully one-fourth - of total equity fundcash flow. Index funds have become the fastest growing segment ofthe entire mutual fund industry.The index fund is a most unlikely hero for the typical investor.It is no more (nor less) than a broadly diversified portfolio,typically run at rock-bottom cost, without the putative benefit of abrilliant, resourceful and highly skilled portfolio manager. Theindex fund simply buys and holds the securities in a particularindex, in proportion to their weight in the index. The concept issimplicity writ large. . . .But since the creation of the first index mutual fund in 1975,based on the Standard & Poor's 500 Stock Index, the concept hasemerged triumphant. . . . I am, if possible, a stronger beliver inthe concept today than I was when I created that fund.After a slow start, the concept has not only steadily gainedacceptance by investors but has come to play a dominant role in theevaluation of traditional, actively managed mutual funds. The indexfund, arguably, is now the standard that dominates the debates aboutinvestment strategy, asset allocation and fund selection. When Ifirst looked at the record in 1975, the S&P 500 Index hadoutperformed the average actively managed mutual fund by about 1.6percentage points per year during the prior 25 years. Updating thestatistics today, its long-term record reflects an annual advantageof 1.3 percent, although in the past 15 years the margin has swelledto 4.0 percent annually. . . .I fully recognize that during the past 15 years the large-capitalization stocks that dominate the S&P 500 Index have led theoverall market by a solid margin. I would emphasize that theaccelerating advantage of the S&P 500 Index may well recede, and mayeven become a shortfall during interim future periods when stockswith smaller market caps return to favor. But its margins ofsuperiority are nonetheless impressive, and surely undergird thepowerful endorsement that index funds have received from the academiccommunity and the financial media, from many astute investmentadvisers and from the investing public. Nearly all of the major no-load fund complexes have now begun to offer index funds - and notonly index funds modeled on the Standard & Poor's 500 Stock PriceIndex. Even the major stock brokerage firms are offering funds on ano-load basis, as is virtually essential. However, they make theirindex funds available only in investment management accounts, whichentail, to whatever avail, an advisory fee that is charged directlyto the client. I fear that this trend is less the result ofenlightenment than of self-interest. Nonbelievers have been dragged- kicking and screaming - into the fray to meet a public demand thatis now palpable. The need for traditional fund managers to fill outtheir product line has outweighed their resistance to accepting themarkedly lower fees that index funds must carry. . . .To state what must by now be obvious, the index fund is here tostay. What began as a controversial idea, bereft of public demand in1975, has come to represent the standard of investment return - butthe apparently unreachable star - for the mutual fund industry. Atlong last, we are witnessing the triumph of experience over hope.Actual experience has reflected the triumph of passively managedindex funds over actively managed funds. Common sense has carriedthe day. In time, index funds will change the very fabric and natureof the mutual fund industry.Excerpted from Common Sense on Mutual Funds: New Imperatives forthe Intelligent Investor. Copyright 1999 by John C. Bogle.Excerpted with permission of the publisher John Wiley & Sons Inc. Toorder a copy of this work call 1-800-CALL WILEY or visit the WileyWeb site at www.wiley.com.