Vanguard funds at 50: How passive investing prevailed
For most individual investors in 1975, access to the markets came typically through mutual funds, pooled accounts holding stocks and bonds in which investors own a share proportionate to their investment. The funds were actively managed, meaning the fund companies bought and sold positions as their forecasts for each security’s prospects waxed and waned. Mutual funds tended to be expensive due to the research and trading costs along with manager salaries, company profits and sales commissions to selling brokers.
A new player emerged on the field that year that would ultimately rewrite the rules of the entire game. Vanguard, today a household name in the fund industry, was founded by another future hall of famer named John C. “Jack” Bogle. Now celebrating its 50th year, Vanguard serves 50 million current investors, but its focus on index investing and low costs has benefited practically all fund investors.
It has long been known that most actively managed funds underperform a relevant benchmark that reflects the fund’s objective. Each year, Standard and Poor’s queries its massive fund database and invariably reports that over the most recent 20-year period, around 95% of all active funds underperform the market after fees and expenses. As early as the late 1950s, researchers recognized the inefficiency of active management. However, at the time there was no way to invest directly in an index like the S&P 500. No such investment vehicle existed.
In 1960, two University of Chicago graduate students wrote a groundbreaking paper that appeared in the Financial Analysts Journal titled “The Case for an Unmanaged Investment Company.” Edward F. Renshaw and Paul J. Feldstein made the case for a passive fund that merely replicated a market index that would obviate the need for individual stock picking and could be operated at lower cost. The first salvo has been fired.
This critique of active management was met with a spirited rebuttal a few months later in the same journal, entitled “The Case for Mutual Fund Management,” a fierce defense penned by an active fund manager writing under the name of John B. Armstrong, a nom de plume for none other than John C. Bogle. Bogle at the time was the CEO of Wellington Management, a large investment company with a vested interest in quashing the upstart passive index approach that threatened its own profits.
More research by luminaries in the finance firmament appeared over the next 15 years in support of indexing. In 1974, Nobel Laureate Paul Samuelson published an article challenging mutual fund companies to create an in-house mock portfolio that channeled a broad index like the S&P 500, primarily for the purpose of providing an unbiased standard against which to measure their performance. Samuelson had also observed that active managers generally failed to beat an objective representative benchmark.
During the mid-1960s, the stock market was on a tear, not unlike the dot com bubble of the 90s, and Bogle wanted in. He oversaw a merger of the conservative Wellington with an aggressive growth manager, a decision that looked brilliant, until it didn’t. As the decade ended, the market crashed, and Bogle was canned in 1974.
As a testament to his tenacity and competitiveness, Bogle pitched Wellington on the idea of starting a new company to handle the complex back office administration of the firm. Wellington agreed, with the proviso that his firm would not manage mutual funds. He named his new venture Vanguard.
But Bogle had also been pondering Samuelson’s work and even engaged in some correspondence with him. In a notable example of self-reflection, he studied the growing body of literature and became convinced that he had been wrong. Sometimes necessity is the mother of reinvention.
Bogle’s answer to the prohibition against running a fund was audacious. He proposed that Vanguard create a passive index that simply mimicked the S&P 500. He could hardly be accused of managing a fund since the fund itself was quite literally unmanaged.
The first true index fund, called the First Index Investment Trust, launched in 1976 and was later renamed the Vanguard 500 Index Trust. Today, the fund holds over $600 billion in assets.
Vanguard fundamentally changed the investment landscape by relentlessly driving down fees and expenses that rob investors of returns over time. So relentlessly in fact that the systemic reduction in fees across the entire industry has been dubbed the “Vanguard Effect,” nudging average fund expenses lower by nearly half since 1989. Bloomberg Intelligence columnist Eric Balchunas wrote in 2016 that Vanguard had saved its customers over $1 trillion of fees since its inception.
Passive index investing was derided and ridiculed as “Bogle’s Folly” during the early years after its debut and took a while to catch on. Vanguard’s initial offering, expected to garner $150 million in investor funds, raised just $11 million. But as time passed and active management continued to underperform, the tide shifted and by 2024, $16 trillion in total assets were invested in passive index mutual funds and exchange traded funds surpassing active funds for the first time.
John Bogle led a fascinating life. He died in 2019 at age 89, still preaching the gospel of low-cost indexing 23 years after receiving a heart transplant. His 1975 epiphany, that active managers fail to beat the market after fees and expenses, was a game changer for millions of investors. Successful investing boils down to two key elements: staying invested through ups and downs and keeping the costs as low as possible. This simple precept is as true today as it was 50 years ago.
Christopher A. Hopkins, CFA, is a co-founder of Apogee Wealth Partners in Chattanooga.