Investors have pulled billions of dollars out of actively managed mutual funds over the last decade. The cause? Index funds. During the 2010s, assets in index funds increased by over 400% while active funds treaded water. In 2019, for the first time in history, index funds had more assets under management than actively managed funds.
On the surface, indexing’s recent explosion in popularity is perplexing. Why would any investor settle for passively taking the return of an index while professional managers are available? Intuitively, managers with all the money and research in the world should be able to outperform a passive, unthinking index.
Intuition is wrong here. History has shown that most active managers underperform the market. The few that do beat the market cannot do it with any sort of regularity. When everyone underperforms the market, using an index fund to get the market return is the best option.
This isn’t the only reason index funds are so popular. Index funds are all-around efficient. They lower both risk and costs, raise returns, and simplify your investment portfolio.
These advantages haven’t arisen by chance. Index funds were tailor-made to provide these benefits. In this article we’ll survey the history of index funds and see what deficits in the mutual fund industry index funds were designed to address. Identifying these deficiencies will reveal the mechanisms that index funds use to provide higher returns, lower costs, and less risk.
Before we jump into the history, let’s briefly review the lingo needed to understand the story of index funds. If you’re already familiar, skip straight to the history.
Index funds have two constituent parts: the mutual fund and the index.
A mutual fund is a pool of money collected from multiple investors. A professional manager manages the fund, placing the money into assets consistent with the fund’s prospectus. Investors receive shares of the fund proportional to their investment.
An index is simply a list of financial products that share a characteristic. The index itself is not a financial instrument; it’s only a list. The Dow Jones Industrial Average and Standard & Poor’s S&P 500 are two particularly famous market indexes. The former tracks the stock prices of 30 of the largest US companies, while the S&P tracks the 500 largest publicly traded U.S. companies weighted by market capitalization.
Indexes aren’t limited to tracking the entire stock market. There are indexes that track individual sectors of the stock market (e.g., technology) or sort companies by their fundamentals (e.g., small-cap or large-cap). There are even indexes for non-stock asset classes like bonds and real estate. If you can make a list of it, there’s an index for it.
An index fund is exactly what it sounds like: a (mutual) fund that tracks a benchmark index. The largest, and probably most well-known, index fund is Vanguard’s Total Stock Market Index (VTSAX) which tracks an index of the entire U.S. stock market.
Index funds are a type of passive mutual fund. Passive funds track an outside metric, such as an index. Their counterparts are active funds. Active funds are a type of mutual fund that has a manager who picks assets that are in line with the funds prospectus.
That’s all the terminology we need. Now, let’s look at the history of index funds.
The history of index funds
While the first index fund appeared in 1976, indexes have been around for much longer. Charles Dow created the first stock market index in 1884, a list of 12 railroad stocks and 2 industrial companies. Over the years, the index morphed into today’s Dow Jones Industrial Average. Due to the investing culture and lack of technology at the time, however, the predecessor to the Dow didn’t lead to the creation of an index fund or even a mutual fund.
The first mutual fund wasn’t created until 40 years later. Called the Massachusetts Investment Trust (MIT), the fledgling fund unpropitiously began operations right before the Great Depression. Against the odds, the fund managed to survive and, by the 1950s, MIT was the largest shareholder in the US. The success of the fund caught the attention of Jack Bogle, the future founder of Vanguard, who was still a Princeton undergraduate at the time.
Bogle was looking for a thesis topic and, after reading an article about MIT in Fortune Magazine, decided to write his thesis on the mutual fund industry. In his thesis, Bogle concluded that mutual funds should minimize fees, not claim to be able to outperform the market, and to focus on the success of the fund long term rather than attempting to maximize short term profits. Written in 1951, 25 years before the debut of the first index fund, Bogle’s conclusions presciently identified the values at the core of index investing.
In his early years before founding Vanguard, Bogle fell for the allure of actively managed funds. After graduation, Bogle found work with a firm called the Wellington Fund. The fund held a diversified basket of common stocks and had similar returns to the Dow. The fund produced solid returns until the 1960s when it began to lag the market. Bogle felt that Wellington’s more passive investment strategy needed to fit the go-go culture of 1960s investing and orchestrated a merger with an actively managed fund, Ivest.
The merger was an unqualified disaster and almost bankrupted the Wellington Fund. Wellington’s returns tanked and investors scrambled to exit the fund. Looking to redeem himself and restore investor confidence, Bogle created Vanguard in 1974 with the aim of putting the principles outlined in his undergrad thesis to work. Vanguard’s initial offering was the first ever index fund, following the blueprint Bogle had laid out 25 years earlier. Though it took several years to gain traction and the fund drastically underperformed its funding goals as an IPO, Vanguard began to steadily grow by the 1980s.
In the beginning, Vanguard had, compared to today, a high expense ratio and even a loading fee (i.e., a sales commission). As it grew though, the loading fee was axed, and expense ratios steadily declined as other competing funds entered the market.
The rest is history. Index funds, led by Vanguard, have triumphantly ousted active managers from their longstanding monopoly on the mutual fund industry. Vanguard and the index fund industry have grown side by side. As of 2021 Vanguard has over 6.1 trillion dollars in assets under management, the majority in index funds or their cousins, index exchange-traded funds (Index ETFs). Expense ratios are now fractions of a percent and there are absolutely no active managers in sight.
So, why index funds?
Let’s return in more detail to the four benefits of index funds that I mentioned in the beginning of this article. After surveying the history of index funds, we can now see exactly why these benefits exist.
1. Higher returns
Bogle’s experience with Ivest beautifully illustrates the superiority of index fund returns. For Bogle’s first decade at the Wellington Fund, the fund’s pseudo-indexing approach yielded respectable returns. As we saw though, this wasn’t enough for Bogle, who became swept up in the irrational exuberance of the 1960s investing scene. As soon as Bogle chased returns and merged with the actively managed fund Ivest, returns cratered. Bogle was barely able to salvage his reputation and was only able to do so through the tremendous success of Vanguard’s index funds.
Bogle’s experience isn’t an anomaly. Study after study has confirmed that actively managed funds consistently underperform index funds. Historically, over 10-to-15-year intervals, the return of index funds tend to rank in the top quartile of actively managed mutual funds with similar objectives. Longer time frames favor index funds even more, with index funds often ranking in the top decile.
Like Bogle, many people, lawyers particularly, find it difficult to settle for the “average” returns of index funds. Lawyers want to feel like they can beat the average and accepting it feels like a defeat. They’ve done well in school and have been trained to analyze situations from every angle. There’s a part of us all that wants to believe that if we just apply our “superior” critical thinking abilities to picking the best stock or the best manager, double- and triple-digit returns will be ours.
As we’ve seen, index funds are only average in the sense that they represent the average return of the market or market sector being tracked. When we instead compare the returns of index funds to those of other investments, index fund returns are decidedly above average. Calling their returns “average” is a misnomer.
We call a journeyman quarterback or a pitcher with a middling ERA “average,” fully understanding that they’re only “average” compared to the Tom Bradys and the Cy Youngs of the world. They’d blow a normal person out of the water. It’s the same for index funds. Yes, index funds are average in the sense they only yield the market return and wont yield Warren Buffett or Peter Lynch level returns. Yet if we look at the entire mutual fund industry, the market average is decidedly amazing.
2. Lower fees
Vanguard’s success shows us the difference low costs make. After a slow start to the first Vanguard index fund, Bogle dropped the load fee and started to move the fund’s expense ratio lower. Unsurprisingly, these cuts coincide with the fund’s reversal of fortune from a lackluster IPO to the juggernaut we know today.
The hallmark of index funds are their rock-bottom fees. A 0.2% expense ratio with no load fee is typical in the industry. Fees are often even lower: Fidelity recently offered the first 0 expense ratio index fund. Actively managed funds, on the other hand, can be expected to have expense ratios around the 0.5% to 0.75% mark, many including an additional load fee. A half-a-percent difference may seem small, but when large sums of money are in play and compound interest is accounted for, that half-a-percent makes a world of difference.
Bogle himself has weighed in on this aspect of index funds with his Cost Matters Hypothesis. In it, Bogle makes the simple yet important claim that you need to account for all transaction costs before looking at your fund’s returns. Bogle settled on the number 2.77%. That is the amount that the average actively managed fund needs to beat the market before it returns the same amount as a low-cost index fund.
The cost savings of index funds aren’t limited to lower fees. Several technical aspects of index funds make them much more tax efficient than actively managed funds. I won’t get into the details in this article. Just know that if you hold your investments in a taxable account, index funds will create less realized capital gains and therefore result in lower taxes.
3. Lower risk
Index funds help investors mitigate two forms of risk: the intrinsic risk of underlying assets and the risk of poor manager performance.
When a fund tracks an index, you no longer need to worry about the fund’s manager making poor decisions. There’s no chance of a young Bogle running your investment into the ground. As we’ve seen, Bogle’s performance isn’t anomalous. Active funds, and thus active managers, struggle to add value and quite often wind-up subtracting value instead.
Index funds are also a way of diversifying, and diversification reduces risk. It’s hard to tell if the value of an individual stock will crater or soar in the next 5 years. Index funds recognize this difficulty and instead buy stocks in all the companies on an index. Some of the companies will likely fail, others will experience large increases in valuation, and the majority will return average results. Index funds come out ahead because as long as the sector or market being tracked grows, the net return of all the individual companies will be positive.
The primary draw of index funds for many investors is their simplicity. If you contribute a consistent monthly amount to a US total market index fund until the day that you retire, you’ll have a substantial nest egg as long as the US economy doesn’t implode. With index funds, there’s no need to compulsively check your brokerage account and fidget with your asset allocation. You don’t need to worry about a negligent manager squandering your investment or an individual company failing.
You can, of course, use index funds to create more complicated portfolios that better suit your investment objectives. Nevertheless, no matter how complicated your portfolio becomes, a portfolio that uses index funds instead of individual stocks or actively managed funds will allow you to avoid a minefield of headaches.
That’s all for the basic advantages of index funds. For those of you looking for a deeper dive, there are dozens of posts about every aspect of index funds on this site. I’d suggest starting with the Biglaw Investor Portfolio for a blueprint for constructing your own index fund-based portfolio.
Joseph Parise is a junior at the University of Buffalo. Joseph grew up in New York and is majoring in Philosophy and Economics. He is currently taking a gap year to study for the LSAT exam and to serve in the US Air Force Reserves.