Who invented the index fund? A brief (true) history of index funds

Pop quiz! If I asked you, “Who invented the index fund?” what would your answer be? I’ll bet most of you don’t know and don’t care. But those who do care would probably answer, “John Bogle, founder of The Vanguard Group.” And that’s what I would have answered too until a few weeks ago.

But, it turns out, this answer is false.

Yes, Bogle founded the first publicly-available index fund. And yes, Bogle is responsible for popularizing and promoting index funds as the “common sense” investment answer for the average person. For this, he deserves much praise.

But Bogle did not invent index funds. In fact, for a long time he was opposed to the very idea of them!

John Bogle did not invent index funds

Recently, while writing the investing lesson for my upcoming Audible course about the basics of financial independence, I found myself deep down a rabbit hole. What started as a simple Google search to verify that Bogle was indeed the creator of index funds led me to a “secret history” of which I’d been completely unaware.

In this article, I’ve done my best to assemble the bits and pieces I discovered while tracking down the origins of index funds. I’m sure I’ve made some mistakes here. (If you spot an error or know of additional info that should be included, drop me a line.)

Here then, is a brief history of index funds.

What are index funds? An index fund is a low-cost, low-maintenance mutual fund designed to follow the price fluctuations of a stock-market index, such as the S&P 500. They’re an excellent choice for the average investor.

The Case for an Unmanaged Investment Company

In the January 1960 issue of the Financial Analysts Journal, Edward Renshaw and Paul Feldstein published an article entitled, “The Case for an Unmanaged Investment Company.”

The case for an unmanaged investment company

Here’s how the paper began:

“The problem of choice and supervision which originally created a need for investment companies has so mushroomed these institutions that today a case can be made for creating a new investment institution, what we have chosen to call an “unmanaged investment company” — in other words a company dedicated to the task of following a representative average.”

The fundamental problem facing individual investors in 1960 was that there were too many mutual-fund companies: over 250 of them. “Given so much choice,” the authors wrote, “it does not seem likely that the inexperienced investor or the person who lacks time and information to supervise his own portfolio will be any better able to choose a better than average portfolio of investment company stocks.”

Mutual funds (or “investment companies”) were created to make things easier for average people like you and me. They provided easy diversification, simplifying the entire investment process. Individual investors no longer had to build a portfolio of stocks. They could buy mutual fund shares instead, and the mutual-fund manager would take care of everything else. So convenient!

But with 250 funds to choose from in 1960, the paradox of choice was rearing its head once more. How could the average person know which fund to buy?

When this paper was published in 1960, there were approximately 250 mutual funds for investors to choose from. Today, there are nearly 10,000.

The solution suggested in this paper was an “unmanaged investment company”, one that didn’t try to beat the market but only tried to match it. “While investing in the Dow Jones Industrial average, for instance, would mean foregoing the possibility of doing better than average,” the authors wrote, “it would also mean tha the investor would be assured of never doing significantly worse.”

The paper also pointed out that an unmanaged fund would offer other benefits, including lower costs and psychological comfort.

The authors’ conclusion will sound familiar to anyone who has ever read an article or book praising the virtues of index funds.

“The evidence presented in this paper supports the view that the average investors in investment companies would be better off if a representative market average were followed. The perplexing question that must be raised is why has the unmanaged investment company not come into being?”

The Case for Mutual Fund Management

With the benefit of hindsight, we know that Renshaw and Feldstein were prescient. They were on to something. At the time, though, their idea seemed far-fetched. Rebuttals weren’t long in coming.

The May 1960 issue of the Financial Analysts Journal included a counter-point from John B. Armstrong, “the pen-name of a man who has spent many years in the security field and in the study and analysis of mutual funds.” Armstrong’s article — entitled “The Case for Mutual Fund Management” argued vehemently against the notion of unmanaged investment companies.

The case for mutual fund management

“Market averages can be a dangerous instrument for evaluating investment management results,” Armstrong wrote.

What’s more, he said, even if we were to grant the premise of the earlier paper — which he wasn’t prepared to do — “this argument appears to be fallacious on practical grounds.” The bookkeeping and logistics for maintaining an unmanaged mutual fund would be a nightmare. The costs would be high. And besides, the technology (in 1960) to run such a fund didn’t exist.

And besides, Armstrong said, “the idea of an ‘unmanaged fund’ has been tried before, and found unsuccessful.” In the early 1930s, a type of proto-index fund was popular for a short time (accounting for 80% of all mutual fund investments in 1931!) before being abandoned as “undesirable”.

“The careful and prudent Financial Analyst, moreover, realizes full well that investing is an art — not a science,” Armstrong concluded. For this reason — and many others — individual investors should be confident to buy into managed mutual funds.

So, just who was the author of this piece? Who was John B. Armstrong? His real name was John Bogle, and he was an assistant manager for Wellington Management Company. Bogle’s article was nominated for industry awards in 1960. People loved it.

The Secret History of Index Funds

Bogle may not have liked the idea of unmanaged investment companies, but other people did. A handful of visionaries saw the promise — but they couldn’t see how to put that promise into action. In his Investment News article about the secret history of index mutual funds, Stephen Mihm describes how the dream of an unmanaged fund became reality.

In 1964, mechanical engineer John Andrew McQuown took a job with Wells Fargo heading up the “Investment Decision Making Project”, an attempt to apply scientific principles to investing. (Remember: Just four years earlier, Bogle had written that “investing is an art — not a science”.) McQuown and his team — which included a slew of folks now famous in investing circles — spent years trying to puzzle out the science of investing. But they kept reaching dead ends.

After six years of work, the team’s biggest insight was this: Not a single professional portfolio manager could consistently beat the S&P 500.

Mihm writes:

As Mr. McQuown’s team hammered out ways of tracking the index without incurring heavy fees, another University of Chicago professor, Keith Shwayder, approached the team at Wells Fargo in the hopes they could create a portfolio that tracked the entire market. This wasn’t academic: Mr. Shwayder was part of the family that owned Samsonite Luggage, and he wanted to put $6 million of the company’s pension assets in a new index fund.

This was 1971. At first, the team at Wells Fargo crafted a fund that tracked all stocks traded on the New York Stock Exchange. This proved impractical — “a nightmare,” one team member later recalled — and eventually they created a fund that simply tracked the Standard & Poor’s 500. Two other institutional index funds popped up around this time: Batterymarch Financial Management; American National Bank. These other companies helped promote the idea of sampling: holding a selection of representative stocks in a particular index rather than every single stock.

Much to the surprise and dismay of skeptics, these early index funds worked. They did what they were designed to do. Big institutional investors such as Ford, Exxon, and AT&T began shifting pension money to index funds. But despite their promise, these new funds remained inaccessible to the average investor.

In the meantime, John Bogle had become even more enmeshed in the world of active fund management.

In a Forbes article about John Bogle’s epiphany, Rick Ferri writes that during the 1960s, Bogle bought into Go-Go investing, the aggressive pursuit of outsized gains. Eventually, he was promoted to CEO of Wellington Management as he led the company’s quest to make money through active trading.

The boom years soon passed, however, and the market sank into recession. Bogle lost his power and his position. He convinced Wellington Management to form a new company — The Vanguard Group — to handle day-to-day administrative tasks for the larger firm. In the beginning, Vanguard was explicitly not allowed to get into the mutual fund game.

About this time, Bogle dug deeper into unmanaged funds. He started to question his assumptions about the value of active management.

During the fifteen years since he’d argued “the case for mutual fund management”, Bogle had been an ardent, active fund manager. But in the mid-1970s, as he started Vanguard, he was analyzing mutual fund performance, and he came to the realization that “active funds underperformed the S&P 500 index on an average pre-tax margin by 1.5 percent. He also found that this shortfall was virtually identical to the costs incurred by fund investors during that period.”

This was Bogle’s a-ha moment.

Although Vanguard wasn’t allowed to manage its own mutual fund, Bogle found a loophole. He convinced the Wellington board to allow him to create an index fund, one that would be managed by an outside group of firms. On 31 December 1975, paperwork was filed with the S.E.C. to create the Vanguard First Index Investment Trust. Eight months later, on 31 August 1976, the world’s first public index fund was launched.

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Bogle’s Folly

At the time, most investment professionals believed index funds were a foolish mistake. In fact, the First Index Investment Trust was derisively called “Bogle’s folly”. Nearly fifty years of history have proven otherwise. Warren Buffett – perhaps the world’s greatest investor – once said, “If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle.”

In reality, Bogle’s folly was ignoring the idea of index funds — even arguing against the idea — for fifteen years. (In another article for Forbes, Rick Ferri interviewed Bogle about what he was thinking back then.)

Now, it’s perfectly possible that this “secret history” isn’t so secret, that it’s well-known among educated investors. Perhaps I’ve simply been blind to this info. It’s certainly true that I haven’t read any of Bogle’s books, so maybe he wrote about this and I simply missed it. But I don’t think so.

I do know this, however: On blogs and in the mass media, Bogle is usually touted as the “inventor” of index funds, and that simply isn’t true. That’s too bad. I think the facts — “Bogle opposed index funds, then became their greatest champion” — are more compelling than the apocryphal stories we keep parroting.

Note: I don’t doubt that I have some errors in this piece — and that I’ve left things out. If you have corrections, please let me know so that I can revise the article accordingly.

Source: getrichslowly.org

The Market Crash Is Coming! (…Eventually)

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Here on the Best Interest, I provide a lot of “you should be investing!” advice. I talk about the power of long-term investments. And stock market strategies. And even about my specific investment choices. But today is different. Today’s post is about the upcoming market crash. Well…it’s coming eventually.

Perhaps you’ve come to believe that I’m an unwavering bull. A pure optimist. That I think investments can do nothing but increase in value. But that’s not true. I know the crash will come. It always does.

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And that might seem scary. If the crash is coming, then why not do something about it? So that’s what today’s post is about. Even though we’re aware that a market crash is coming (eventually), we can take a step back and think about it rationally.

Being a Bull Before the Market Crash

Here’s a prediction.

I predict that I will eventually make a blog post where I say something like,

“I bought some shares of an index fund this month—just like every other month. And I think it’s one of the smartest things you can do as an investor.”

And after that future blog post, the market will proceed to fall 30% over the next few months.

Some people will then look at the Best Interest and think, “Pfff! This guy Jesse doesn’t have a clue what he’s talking about! He invested a few thousand bucks right before the market crashed!! What a dummy!”

I’m calling it now. It’ll happen. And I understand why it will appear like I’d be a dummy.

So let’s dig in. Am I a dummy?

Dummy Test GIFs | Tenor

Historical Data: The Market Crash Always Comes

The market crash always comes eventually.

Bear markets—where the stock market value drops by 20% or more from its previous high—have occurred 12 times since 1929.

Years of Bear Markets Percent Drawdown from Previous High
1929 – late 30s (Great Depression) -86%
1956 – 57 -22%
1961 – 62 (Flash Crash of ’62) -28%
1966 -22%
1968 – 70 -36%
1973 – 78 (Bretton Woods + Oil Crisis) -48%
1980 – 82 -27%
1987 – 88 (Black Monday) -34%
1990 -20%
2001 – 05 (Dot Com Bubble) -49%
2008 – 09 (Financial Crisis) -56%
2020 (COVID) -32%

The market ebbs and flows, oscillating between “unsustainable optimism and unjustified pessimism.” If we believe the assumption that stock prices are current unsustainably optimistic, then it’s believable that a serious bear market could happen in the next few years.

But lesser corrections—typically defined as at least a 10% drawdown—occur even more frequently. Since 1950, there have been 37 corrections of 10% or more. That’s more frequent than one every two years.

It doesn’t take Nostradamus to predict a future market downswing. I’m not calling a 1-in-1000 event. Market corrections happen all the time.

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“But if he gets elected…!!!”

You can find arguments from both sides of the political aisle that certain parties lead to better stock market performance. But let’s investigate the data itself.

First, let’s look at the president only. But heed warning: this is a slightly dangerous game. Does the president alone have enough influence to affect the stock market? Will the answers we find here be conclusive of causation? Or will they only present correlation?

From 1926 to 2020, we have 95 years of S&P 500 data. During that time, we’ve had 48 years of Democratic leadership and 47 years of Republican leadership. Republican years saw an average S&P 500 return of 9.0%, while Democratic years saw an average return of 14.9%.

That’s a pretty big difference! But is it causal i.e. one thing causes the other to occur? Can a system as complicated as the stock market be tied down to a single influencing variable like the president’s political party? Probably not.

After all, that’s only 23 presidential terms and 15 individual presidents. Eight Republicans and seven Democrats. Not exactly a huge sample set.

Keep this in mind for the next time a President tweet-brags about the stock market’s success.

President + Congress

But there is another working theory worth inspecting. The theory is that our government is more efficient when the Congress (both Houses) is controlled by the President’s party. If the President and Congress work together effectively, then we all benefit. It’s a “teamwork makes the dream work” situation.

In the 95-year period since 1926, we’ve had 48 years of President/Congress unification (14 years Republican and 34 years Democrat) and 47 years of division (33 with a Republican president and 14 with a Democrat). The market performance during these periods is very interesting.

President / Congress S&P 500 Average Annual Return
Dem / Dem (34 years) 14.5%
Repub / Repub (14 years) 13.9%
Dem / Repub or Split (14 years) 15.9%
Repub / Dem or Split (33 years) 7.0%
Total Unified (48 years) 14.3%
Total Divided (47 years) 9.7%

Is this causal? Does a unified Federal government ensure that the economy and stock market perform better? I doubt it’s conclusive. But it is interesting nonetheless.

The market trends upwards no matter who is in office, but it appears that political cooperation might help grease the wheels.

The Silver Lining of Market Crashes

Back when we consulted Mr. Market, one big takeaway was:

The only two prices that ever matter are the price when you buy and the price when you sell.

Ask yourself: what are your investing plans are for the next few years? Are you going to be a buyer—someone who is investing for the future? Or are you going to be a seller—someone who has invested for the past few decades and now wants to live off those investments?

If you’re a buyer, then a market crash has a pretty significant silver lining. Cheaper prices! If the market declines, then you get to invest at lower prices. It’s the easiest way to increase your long-term investing potential. Buy low, sell high. Dollar-cost average investors relish these chances to decrease their cost basis.

If you’re a seller, let’s look at how your past 30 years have been. The S&P 500 value was around ~350 in 1990. And now it’s at ~3500, or about 10x higher. If the market drops 20% next week to 2800, then your returns are only ~8x compared to 1990. But an 8x return ain’t bad!

“If the market crash is coming…why not sell now and wait to re-invest after the prices drop?”

Before I answer the question above, let’s consult Peter Lynch—who is considered one of the most successful investors of all-time.

Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves.

Peter Lynch

What exactly is Lynch saying? How do people lose money by “preparing” for corrections?

People lose money “preparing” for corrections because they sell too soon and then don’t know when to buy back in. It’s that simple. Both actions—selling too soon and not buying back in soon enough—can cause investors to miss out of years of growth and years of dividends.

That’s why Peter Lynch’s quote rings so true. Timing the market is hard.

So we don’t sell in preparation for a crash. But what about saving up cash and waiting to buy? Why not hold cash, wait for the 10% drop (that we know happens every 2 years, or so) and buy in then?

Well, I looked at that too. Back in March ’20, my “Viral Stock Market Strategies” article (get it? viral?!) looked at an assortment of supposed strategies that involved holding onto cash while waiting for the market to drop. I back-tested these strategies against the historical S&P 500 data, and simple dollar-cost averaging beats all the “wait for a drop” strategies.

You think there’s a market crash coming? I know, me too (eventually). There’s certainly a chance that holding onto cash and waiting for the crash is correct right now. But if you try that tactic over time, it’s a losing strategy.

Don’t sell. And don’t wait to buy. Carry on with your normal investing cadence.

Don’t do something. Just sit there.

Jack Bogle

“But what if it’s the crash?!”

What if what’s coming is the big market crash? The mother-of-all-crashes! What if society falls apart? Or if a meteor hits Earth and life changes as we know it? What if we all start scavenging for beans and scrap metal and fuel for our souped-up dirt bikes?

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Mad Max – where fuel and water are all that matter.

Scary questions, but they have a pretty simple answer. If an existential threat ruins your investments, then the stock market will be the least of your worries. That’s it. If “the big one” hits, then the stock market will be one of many societal structures that no longer matter.

If it’s not “the big one,” then the market will recover. It always does.

Why? Why does the market always bounce back? In part, it’s because humans are resilient. We learn and grow and work towards progress. While this year’s COVID market recovery can be attributed to many different factors—like the Federal Reserve lowering interest rates—it can also be attributed to human resiliency.

If “the big one” is coming, then shouldn’t you just “YOLO” and spend your money now? Yeah, you should. I suppose we all need to do some probability analysis.

  • What are the odds that “the big one” is about to come and you look stupid that your investments become worthless?
  • What are the odds that “the big one” never comes and you wish that you had invested in your younger years to enable retirement?

I’ll take my chances and save for retirement.

Crash Landing

So, am I a dummy? I hope I’ve convinced you otherwise.

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Even though we know that the stock market will eventually succumb to 10%, 20%, or even larger drawdowns, there’s no basis that you’ll benefit by trying to wait or time that market crash. It might work, but it usually doesn’t. That’s what the historical data tell us.

Waiting for the election doesn’t matter either. Democrats, Republicans…the market does its own thing. There might be some causality, but it’s tough to tell.

There are silver linings in corrections and crashes. If you’re investing for the long-term, then corrections enable cheaper prices and greater returns.

And if this market crash is “the big one,” then none of this really matters. It’s hard to blog if the electrical grid fails.

If you enjoyed this article and want to read more, I’d suggest checking out my Archive or Subscribing to get future articles emailed to your inbox.

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Tagged crash, stock market, timing

Source: bestinterest.blog