THE INCREASED POPULARITY OF PASSIVE INVESTING
Many investors have realized that the poor performance of actively
managed funds relative to benchmark indexes strongly implies that they
would do very well to just equalthe market return of one of the broad-
based indexes. Thus, the 1990s witnessed an enormous increase in pas-
sive investing, the placement of funds whose sole purpose was to match
the performance of an index.
The oldest and most popular of the index funds is the Vanguard 500
Index Fund.^12 The fund, started by visionary John Bogle, raised only
$11.4 million when it debuted in 1976, and few thought the concept
would survive. But slowly and surely indexing gathered momentum,
and the fund’s assets reached $17 billion at the end of 1995.
In the latter stages of the 1990s bull market, the popularity of in-
dexing soared. By March 2000, when the S&P 500 Index reached its all-
time high, the fund claimed the title of the world’s largest equity fund
with assets over $100 billion. Indexing became so popular that in the
first six months of 1999 nearly 70 percent of the money that was invested
went into index funds.^13 By 2007, all Vanguard 500 Index funds had at-
tracted over $200 billion in assets, but the largest single equity mutual
fund is the American Growth Fund with assets of $185 billion.^14
One of the attractions of index funds is their extremely low cost. The
total annual cost in the Vanguard 500 Index Fund is only 0.18 percent of
market value (and as low as 2 basis points for large institutional investors).
Because of proprietary trading techniques and interest income from loan-
ing securities, Vanguard S&P 500 Index funds for individual investors have
fallen only 9 basis points behind the index over the last 10 years, and its in-
stitutional index funds have actually outperformed the index.^15THE PITFALLS OF CAPITALIZATION-WEIGHTED INDEXING
Despite their past success, the popularity of indexing, especially those
funds linked to the S&P 500 Index, may cause problems for indexCHAPTER 20 Fund Performance, Indexing, and Beating the Market 351
(^12) Five years before the Vanguard 500 Index Fund, Wells Fargo created an equally weighted index
fund called “Samsonite,” but its assets remained relatively small.
(^13) Heather Bell, “Vanguard 500 Turns 25, Legacy in Passive Investing,” Journal of Index Issues, Fourth
Quarter 2001, pp. 8–10.
(^14) Vanguard’s number includes assets of its 500 Index Fund open to both individuals and institu-
tions.
(^15) The Vanguard Institutional Index Fund Plus shares, with a minimum investment of $200 million,
have outperformed the S&P 500 Index by 7 basis points in the 10 years following the fund’s incep-
tion on July 7, 1997.