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A Brief History of Indexing

My, how index funds have grown since the first one launched almost 35 years ago.

This month, Bogle's Folly celebrates its 35th birthday.

For those unfamiliar with the history of index funds, Bogle's Folly is the  Vanguard 500 (VFINX), the world's first index mutual fund. On Aug. 31, 1976, it launched as the First Index Investment Trust with little fanfare but soon attracted much derision for its central premise: That just buying and holding the broad stock market would provide better results than trying to beat it by picking stocks. Though many academics and practitioners had been promoting the idea of a market portfolio for years before Vanguard founder Jack Bogle made the 500 available, much of the investing establishment at the time dismissed it as a recipe for average results and even called it un-American.

Now index funds are right up there with mom, baseball, and apple pie. At the end of June, there were nearly 290 distinct stock and bond index mutual funds in the United States and 990 U.S.-based passive exchange-traded funds with nearly $2.3 trillion in assets. That's still less than a third of the $7.3 trillion in actively managed funds, but passive investing inexorably continues to gain ground. For the year ended June 2011, long-term passive funds and ETFs took in more than $183 billion in new inflows, while actively managed funds garnered nearly $138 billion. Broadly diversified index funds' market share increased to 22.3% in May 2011 from 20.7% a year earlier, while active funds' portion dropped from 77.8% to 76.1%.

Onward, Passive Soldiers
Despite predictions to the contrary, more often than not settling for an index fund has led to above-average returns. More than half of U.S.-domiciled index funds, including those that have been liquidated or merged away over the years, finished in the top two quartiles of their respective categories in the one-, three-, five-, 10-, and 15-year time frames ended July 31, 2011.

Index funds may not have anything to prove anymore, but new challenges have come with their success. A lot of suspect investments and strategies are trying to ride the coattails of the indexing movement. Particularly among ETFs, there's been a profusion of narrowly focused, more-expensive niche index funds tracking obscure asset-class slices such as corn, Andean companies, lithium miners, and battery makers. In the past decade, even Vanguard, a bastion of broad-based indexing, has launched sector index funds and ETFs, albeit more-diversified ones than other ETF sellers have introduced. There's also been an explosion of leveraged index funds and ETFs that promise to produce 2 times the return or the inverse of their benchmarks. Their purveyors pitch these products as tools for active index investing--an approach that can involve trying to beat the market by tactically trading chunks of it, which is hard to make work over the long term.

These funds and approaches stretch the founding principles of indexing--buying and holding a broadly diversified basket of securities at low cost--to the breaking point. When they burn unwitting investors who buy them without understanding them or who unsuccessfully use them to make short-term market calls, they besmirch the good name indexing took four decades to build.

Weighty Matters
Indexing success also has attracted rivals trying to improve on traditional passive investing approaches. There has been a proliferation of indexes that weight their constituents by measures other than market capitalization--the standard construction methodology for four decades. Most prominent among them are the fundamentally weighted indexes developed by Robert Arnott's Research Affiliates. These benchmarks rank their constituents by book value, dividends, sales, and cash flow instead of market value and are tracked by several funds and ETFs, such as  PowerShares FTSE RAFI US 1000 Index (PRF). That ETF has done well relative to Vanguard 500 and  Vanguard Total Stock Market Index  (VTSAX) since its late 2005 inception, but it also has taken on more risk by tilting toward mid- and small-cap value stocks. That's been a good bet in recent years, and there is a wealth of academic research supporting the idea that small and value stocks tend to outperform over long periods. Still, fundamentally weighted indexing is less a new form of passive investing than a systematic, active wager against the market. That may prove to be a fine long-term strategy, but it's not pure indexing and not a sure thing.

'Tis a Gift to Be Simple
The firm that popularized indexing hasn't adopted fundamental weighting and likely won't. In a recent interview with Morningstar Advisor magazine, Vanguard chairman and CEO Bill McNabb contended weighting indexes by dividends or other factors "are just that, factor bets" that ultimately could disappoint investors when growth and large-cap stocks outperform.

No matter if time proves fundamental indexing to be a disappointment or not, I think the long run will show that buying and holding a balanced portfolio of broadly diversified index funds remains a pretty good way to get a fair share of the markets' returns after fees, taxes, and transaction costs. The performance of Vanguard's Target Retirement funds is encouraging. The funds, most of which rely on just three index funds--Vanguard Total Stock Market Index, Vanguard Total Bond Market II Index (VTBNX), and  Vanguard Total International Stock Index (VGTSX)--all have performed well in the past five tumultuous years, posting absolute annualized gains ranging from 3.7% to 5.9% and ranking in their categories' top fourth.

Such simplicity has been the secret of indexing's success. As the birthday of the first index mutual fund approaches and passive investing seems to be getting more complex and active all the time, investors should remember that.

 A version of this article originally ran in Morningstar's Vanguard Funds Family Report.

Dan Culloton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.