Paul Volcker, the former Federal Reserve chairman, famously said in 2009 that the most important financial innovation over the past 20 years was the invention of the ATM. Perhaps if he had looked back an additional 20 years, he might have picked another great innovation: index funds.

Index funds, which evolved from academic theory to practical investment vehicle in the late 1970s, now make up nearly half the assets in recordkept plans here at Vanguard. They have forever altered the investment landscape for the better, in my opinion.

Before the emergence of index funds, investors had two primary paths to equity exposure: individual securities selection or active portfolio management. Both approaches require a lot of time and more cost.

Building a portfolio of individual securities entails hours of research, poring over specific stock information, and executing numerous transactions. Then oversight requires continuous monitoring and rebalancing.

Active management in a fund, on the other hand, allows investors to turn over the day-to-day decisions to a qualified portfolio manager. But even professional money management creates a level of portfolio “manager risk.” Since the portfolio manager’s ultimate job is to add alpha, the manager must deviate from market-cap weights in search of excess return above a benchmark by creating overweights (or underweights) in individual securities or industries. Yet the stock market might move in unanticipated directions, and an overweight in, say, information technology, can result in underperformance if tech stocks take a nose dive. I’ve seen it happen all too often.

And, as you can see, it’s difficult for active managers to outperform their indexed peers, especially when accounting for funds that were closed or merged during the 10-year period ending December 31, 2012. Even when looking only at surviving funds, more than 50% of the managers underperformed the average low-cost index fund in five out of the five categories shown here—some of them by much more than 50%. This broad underperformance is largely due to the difference in costs.

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Which leads us back to what I believe is the beauty of the index fund: low-cost, diversified, risk-controlled, and 100% invested every day. Several of my colleagues have come to a similar conclusion with their post The adoption of a great idea. They focus on the rise of broad-based, low-cost investments. To me, low costs have caught on across investment types in large part due to index funds. I’m taking it a step further here by honing in on the growth and adoption of the index fund in particular. While index funds have been around for some time, we’re now seeing indexed assets outpace active assets in growth of market share and adoption, which I think is a good thing for investors.

In Darwinian terms, low-cost index funds have survived their actively managed cousins over the past 30 years. Looking at it from market share, index funds represented 0% of equity mutual funds in 1975, and today they constitute more than 30% of the market. Our data show that in 2004, actively managed assets exceeded indexed assets in Vanguard defined contribution plans, with 40% of assets in active funds, 28% in indexed offerings, and the remainder in “nonindexable” assets  such as money market, stable value, or company stock. By year-end 2012, that shifted quite dramatically, with 45% of assets in indexed options, 31% in active, and 24% in “nonindexable” assets.

For you, the availability of index products provides an opportunity to ensure your retirement plan or investment portfolio includes a healthy offering of indexed options to make sure you’re taking advantage of what I see as one of the most important financial innovations of the past 40 years.

 

 

 

Notes: 

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Investments in target-date funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the work force. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in target date funds is not guaranteed at any time, including on or after the target date.