Sergeant Pepper's Index Fund

(Sung to the tune of "Sgt. Pepper's Lonely Heart's Club Band")

"It was 30 years ago today.
John Bogle taught us how to play.
Index investing is the style,
And it's guaranteed to raise a smile.
So let me introduce to you
The Vanguard S&P 500 Index fund."

Vanguard 500 Index Fund (VFINX) celebrated its 30th birthday last August. The concept of tracking an index was derided at the time as guaranteeing mediocrity. The investing public showed little interest; its initial offering fell short of the $80 million projected, garnering only $11.3 million worth of shares. At the end of last year, measured by assets across all share classes, Vanguard's Index 500 fund was the largest mutual fund in the U.S.

The success of the index fund has spawned exchange traded funds (ETFs) and other passive investment strategies. So the question now is, what's the best approach?

Kudos to Barclays for initiating iShares, but having 116 makes little sense. The Dow Jones Select Dividend Index (AMEX: DVY  ) works great to generate cash flow. Also, the iShares COMEX Gold Trust (AMEX: IAU  ) is a unique way to invest in gold. That having been said, every country in the United Nations General Assembly does not need an ETF. More importantly, some of the esoteric ETFs have high expense ratios and trade at a premium to their net value. And the plethora of ETFs from iShares may tempt some people to try their hand at market timing. Market timing is like eating while driving -- people overestimate their proficiency. By contrast, Vanguard has only 20 or so ETFs with significantly lower expense ratios than iShares.

A new concept in the ETF arena is from WisdomTree, where indices are constructed with heavier weighting to dividend paying stocks. Eighteen of WisdomTree's 20 ETFs beat their cap-weighted benchmarks for Q3 2006. Does this mean WisdomTree is superior to conventional index funds, or are we comparing apples and oranges? Time will tell. The beauty of index investing is that you get exposure to specific asset classes, and that's the first step to diversification.

Isn't it amazing that the concept of tracking an index as an investment tool that barely got off the ground 30 years ago has changed investment options so profoundly?

Happy birthday, VFINX! We certainly have enjoyed the show.

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Fool contributor Buz Livingston, CFP, welcomes your comments. He does not own any of the ETFs mentioned in this article.

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