On July 4, 1776, the Second Continental Congress, gathered in Philadelphia, to adopt the Declaration of Independence. Two hundred years later, some 20 miles west of Independence Hall, in a nondescript office park near Washington’s Valley Forge headquarters, John C. Bogle and the fledgling Vanguard Group launched the first index mutual fund, a declaration of independence from ruinous investment fees. On August 31, the indexing revolution will mark its 37th anniversary.

A slow start

The case for indexing had been established in the 1960s, with pioneering research by Eugene Fama, Paul Samuelson, Michael Jensen, and others. By the early 1970s, a few pension funds had adopted index strategies.¹ For the most part, however, indexing remained hidden in the proverbial ivory tower, unavailable and incomprehensible to the investing public. How could an unmanaged portfolio possibly compete with funds managed by talented human beings, wise in the ways of investment analysis and Wall Street?

Indexing was indeed slow to catch on. In 1976, a group of underwriters headed by Dean Witter & Co. led an initial public offering of Vanguard’s First Index Investment Trust, the original name of the Vanguard 500 Index Fund. (In 1977, Vanguard went “no-load” and began selling shares directly to investors.) The underwriters expected to raise $150 million. When the fund began operations, its assets totaled a mere $11.4 million, not enough to buy every stock in the S&P 500 Index.

Rise to prominence

Vanguard 500 Index Fund had a relatively low profile until the mid-1990s, when the strategy began to attract acclaim from the financial press and cash from investors. From the start of 1995 to the end of 1999, the Vanguard 500 Index Fund’s assets increased from $9 billion to more than $100 billion. At Vanguard, there was some ambivalence about the rapid growth. Did indexing’s newfound popularity reflect an appreciation for the strategy’s virtues? Or were investors simply chasing the performance of the S&P 500 Index, which returned an astonishing 28.6% per year for the 5 years through 1999 as the bubble in large-cap tech stocks inflated? These days, there’s no doubt that investor enthusiasm for indexing is more about its enduring virtues: low costs, broad diversification, and precisely defined portfolios.

The indexing virtues: Cost, diversification, precision

Cost is the index fund’s most important advantage. In competitive capital markets, where fractions of a percentage point can mean the difference between above- and below-average returns, low-cost funds start the performance derby with a big head start.

Rather than conduct expensive investment research, index funds simply buy and hold all the securities in an index (or a representative sample), which keeps their operating costs low. Because of their buy-and-hold strategies, index funds generally have lower portfolio turnover and transaction costs than actively managed funds.

At the end of 2012, the average dollar-weighted expense ratio of actively managed large-cap stock funds was 0.82%, according to Vanguard calculations using Morningstar data. For large-cap index funds, the dollar-weighted average was 0.11%. Some charge less than half as much. Over time, lower-cost funds have tended to outperform their higher-cost counterparts. For a taxable investor, a broad-based index fund can mean lower tax costs too.²

Index funds allow for diversification across an entire market or market segment, taking no more (and no less!) risk than the market itself. Diversification can’t protect against a loss, but it’s the most effective way to limit the risks associated with a particular company, market segment, or asset class.³

Index funds can also simplify portfolio construction. A portfolio’s mix of stocks, bonds, and other assets is the primary driver of its long-term returns and the variability of those returns.⁴ Index funds are the most precise way to implement a target asset allocation. An index fund is designed to deliver the risk and return characteristics of a particular market segment. In an effort to deliver benchmark-beating returns, active funds take on risk and return characteristics different from those of the relevant index. Active strategies offer the opportunity, if not the guarantee, to earn superior returns, but they add a degree of fuzziness to the asset allocation process.

Happy birthday

After a slow start, the indexing revolution has continued to gather momentum as investors embrace the benefits of low costs, broad diversification, and precisely engineered portfolios. Today, assets in the Vanguard 500 Index Fund and its institutional counterpart, Vanguard Institutional Index Fund, total more than $270 billion. As of June 30, 2013, Vanguard managed more than $1 trillion in all stock index funds and another $260 billion in bond index funds.

The revolution that began a short horse ride from Independence Hall has transformed Philadelphia into a center of gravity in the investment management industry, even as its influence reverberates around the globe.⁵ On August 31, when the Vanguard 500 Index Fund celebrates its 37th birthday, I’ll dine on a cheesesteak and raise a prospectus to toast the many ways that this second Philadelphia revolution has changed our lives for the better.

¹ For more on the development of indexing, see Capital Ideas by Peter Bernstein (Macmillan, Inc., 1992) and Common Sense on Mutual Funds by John C. Bogle (Wiley, 1999).

² Philips, Christopher B., 2012. The case for indexing. Valley Forge, Pa.: The Vanguard Group.

³ Bennyhoff, Donald G., 2009. Did diversification let us down? Valley Forge, Pa.: The Vanguard Group.

⁴ Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower, 1986. Determinants of Portfolio Performance. Financial Analysts Journal 42(4): 39–48.

⁵ See Bogle, John C., forthcoming, 2013. Big Money in Boston, Journal of Portfolio Management.

Notes: The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.