The roots of index investing

Posted by on May 4, 2011 @ 9:01 am in Investing

In our own quiet way, we’re celebrating 35 years of indexing at Vanguard this year. (Hey, you wouldn’t expect party hats and champagne at Vanguard!)

Indexing is an amazing success story—and not just at Vanguard. From a controversial, much-derided idea back in 1976, index investing has grown to be a widely accepted investment approach today.

As our Vanguard 500 Index Fund approaches the big 3-5 (it began in 1976 as First Index Investment Trust), I got to thinking about indexing’s family tree. That tree has roots in both the groves of academe and the rough-and-tumble “real world” of active investment management, where portfolio managers compete tenaciously to outperform each other.

The academic roots of indexing (and many other finance and investment innovations) are explored brilliantly in Capital Ideas, a marvelous history of modern finance by the late Peter L. Bernstein, who was both a scholar of investing and a practitioner. Finance theory laid the intellectual foundation for indexing—although it took years before the theory led to actual indexed portfolios.

In 1973, in his classic investment book, A Random Walk Down Wall Street, Princeton University professor Burton S. Malkiel attacked the notion that professional investors as a group could beat the financial markets. He suggested creation of a low-cost mutual fund “that simply buys the hundreds of stocks making up the market averages and does no trading (of stocks).” In 1974, the case for a market index fund was made in a Journal of Portfolio Management article by Paul A. Samuelson, an MIT professor and 1970 recipient of the Nobel Prize in economics. In his article, Samuelson said that active portfolio managers should have to test their mettle against a portfolio tracking a market index, suggesting that someone—perhaps a nonprofit foundation—should create such a portfolio.

The “practical” case for indexing came in “The Loser’s Game,” a 1975 article in The Financial Analysts Journal, written by Charles D. Ellis, president of the institutional investment consulting firm Greenwich Associates. Mr. Ellis wrote that investment management “has become a Loser’s Game” because large institutional investors had, in effect, become the market. As a group, they earned the market return—before deducting the expenses of administration, research, commissions, transaction costs, and so on. Mr. Ellis suggested that those expenses created a hurdle that few managers could overcome in the long run. So investors stood the best chance of winning simply by losing fewer “points” than their competitors. While his article didn’t call for creation of an index fund, Mr. Ellis wrote that “if you can’t beat the market, you should certainly consider joining it. An index fund is one way.”

The Samuelson and Ellis articles—and a third article from Fortune magazine—have been cited by Vanguard’s founder, John C. Bogle, as inspirations for his creation of the first index mutual fund, First Index Investment Trust.

“Confronted with those three articles,” Mr. Bogle wrote years later, “I couldn’t stand it any longer. It now seemed that the newly formed Vanguard Group (then only a few months old) ought to be ‘in the vanguard’ of this new logical concept.”

Incidentally, both Professor Malkiel and Dr. Ellis later served on Vanguard’s board of directors. And that first index mutual fund, started in 1976 with a bit more than $11 million in assets, has now grown to almost $110 billion.

Tall oaks do indeed grow from little acorns.

Notes: Like all investments, mutual funds are subject to risks. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Past performance is not a guarantee of future results. Asset figures cited here are as of March 31, 2011.

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