The Index Fund Story, Told by Jack Bogle

John C. Bogle is the founder and retired CEO of The Vanguard Group, the largest mutual fund organization in the world, comprised of more than 160 mutual funds with current assets totaling more than $1.4 trillion. Since his retirement from Vanguard in 1996, Bogle has spent his time studying, writing, and speaking on the financial markets and mutual funds. He is president of the Bogle Financial Markets Research Center, created in 2000 to support his ongoing work on behalf of investors.

"When you think about it, we're all indexers," Bogle says. Some investors are indexed directly, while everyone else, cumulatively, owns the index itself. In this video segment he tells the story of the mid-'70s when index funds were the enemy, and why he believed in them anyway.

Tom Gardner: Thirty-nine years ago, almost to the day -- a little bit longer than 39 years ago -- you started The Vanguard Group. Jack Bogle, one of our heroes at The Motley Fool for so many different reasons -- which will come out, hopefully, in our conversation.

It starts with simplicity and clarity, integrity, and a solution that is transparent in a financial industry that works so hard against those qualities, it seems, many times. What was life like for you in 1974? Can you paint a little bit of the picture of what Vanguard was then, compared to what it is today?

Jack Bogle: Sure, and this will not be very surprising to anybody that's ever started what we call in the modern age -- we didn't use the term then -- a "disruptive" technology. We were shrinking. When we finally broke up the Wellington Management Co. into certain operating units and Vanguard took over the administration, we were going downhill.

One of the directors said, "Bogle, do you realize we're hemorrhaging?" Realize it? We had more money going out than coming in for 83 months! So you've got to be kind of blind, you've got to be kind of stupid, and you've got to think it's great news when a month's cash flow goes from $20 million out to $19 million out.

Everybody condemned the index fund. Ned Johnson said, "Our shareholders would never want a fund with average performance."

Gardner: "Mere average."

Bogle: By the way, that was the year -- 1976, probably -- when all the Fidelity funds had fallen out of bed, and they weren't getting anything like average performance, just for the record.

For whatever that philosophical bent was on his part -- nice enough to say -- they now have a $150 billion index fund business, so we've seen this huge swing.

"Help stamp out index funds. Bam! Bam! Bam!" -- that big Wall Street poster. Everything was negative. The Wellington Fund had been just about destroyed by our partners from Boston, from an investment standpoint. That was the flagship of the Vanguard fleet, and it dropped from $2.1 billion to $400 million. The performance was the worst in the industry for any balanced fund.

There wasn't a lot of good news around. All the funds that were part of the merger went out of business -- the Ivest Fund, finally -- funds that people had never heard of -- the dustbin of history, we say. One called Technovest, using technical market analysis -- yes, Wellington bought out such a fund -- and a fund for trustees called Trustees Equity Fund, the first one. It crumpled like tissue paper in a fire, to pick a metaphor!

So, everything was bad. You had to know you were right in the long run. You had to know that gross return in the financial markets, minus cost, equals net return. Pretty smart here -- that's the underlying principle.

I didn't really phrase it this way in those days, Tom, but when you think about it, we're all indexers. Every investor in America is an indexer because 25%-30% -- let's call it 25% -- is indexed, but the other 75% own the index, but one at a time. That's the total market, and if you have the total stock market fund, you either own it as a unity or you own little chunks of it and somebody else owns the rest.

Will the unity, let's call it the "unity business," of the index fund do better than the trading business, for all these other people that own the index -- trading with one another -- and try to outpace them, which of course can't be true, and they pay their little helpers, and therefore they have to lose.

It's all so clear that it is a disruptive technology, and it works. But anytime you try to introduce a new idea, first it's, "It will never work." Then, "It will work, but only for a short time." Then, "The guy's really lucky." And finally, "You know, he's right."

Gardner: Do you think, during the "Guy's really lucky" phase -- or is there a phase in there -- where it is "The guy's a threat and we're going to say whatever we can to confuse people about the solution that he's putting in the market?"

Bogle: Well, they can try that, but it's too late for that. It's too late.

In the last five years, roughly, $400 billion has gone out of actively managed funds and $600 billion has gone into index funds. It's a trillion-dollar swing, just for the equity part of the business. It's probably around $6 trillion or $7 trillion. It's a huge swing in five little years -- so the market is responding.

Even the people that don't like it at all are doing it, because the client insists on it. Part of the insistence is going in the wrong direction -- and that is, we have the ETF, which is a way of trading the index fund all day long, in real time. What kind of a nut would do that?

Gardner: Well, there are a lot of nuts out there, right?