The world’s first index mutual fund for individual investors, now called Vanguard 500 Index Fund, got a frosty reception when it was launched on August 31, 1976. Initially, it was a hard sell: The fund raised a disappointing $11.4 million in assets at its public offering.
The lack of enthusiasm was understandable. Vanguard wasn’t just introducing a new fund; we were proposing a different way of investing—until then, active management had been the only game in town. The pitch for indexing wasn’t outperformance; it was to help investors minimize the cost of investing in a broad sense. If you think about it, not being broadly diversified has a cost, portfolio turnover generates transaction and tax costs, and, of course, active management advisory fees are a cost. Indexing hits at those headwinds straight on. That has helped it evolve from a derided experiment to the default investment approach for many investors and retirement programs. According to Strategic Insight, index strategies accounted for about 34% of mutual fund and exchange-traded fund assets at the end of 2015—an astounding shift from zero to about $3.47 trillion in assets in just 40 years.
It’s obviously not dinnertime conversation in a lot of households, but there have been plenty of innovations in indexing since 1976, and Vanguard has influenced a good number of them. For many years, Vanguard has brought methodology improvement ideas to the table in regular discussions with the major index providers. For instance, to improve investability, we pushed for indexes to reflect the free float of a company, as opposed to just shares outstanding. We’ve also partnered with index providers on setting capitalization cutoffs between large-, medium-, and small-cap stocks, smoothing stock transitions between those categories when indexes rebalance, and coming up with more robust criteria for identifying growth and value stocks. That has been a win-win for the index providers and our clients, as these methodology improvements have helped indexes become more investable and behaviorally more similar to how you would want a long-term, diligent investor to manage a well-diversified pool of assets.
We’ve also found opportunities over the years to improve how we manage our index funds here at Vanguard. Continuing to lower costs is an important aim because it improves an investor’s net return. Some explicit costs, such as commissions and custody costs, have come down, as rising assets under management have created increasing economies of scale for our funds. Indexers also face implicit costs associated with the potential impact of executing trades in the market. Developing techniques and strategies to minimize these transaction costs has been a hallmark of Vanguard’s index management approach, allowing investors to keep more of their returns.
Probably the biggest change indexing has brought to investing is that it has opened everyone’s eyes to the importance of costs. Investors have clearly gotten the message given the phenomenal cash flows into index funds, which are possibly the purest form of low-cost investing. Many active managers have as well. With index funds as inexpensive options for capturing the market return, the bar has risen for managers to produce investment performance in excess of the market return after fees—a feat that has proven difficult over multiyear periods. In that sense, the advent of indexing helped to bring down investment costs across the entire mutual fund industry, a win for both index and active investors.
- All investing is subject to risk, including possible loss of principal.
- Diversification does not ensure a profit or protect against a loss.