Insider Darwin Abrahamson

In 1949 John C. Bogle, the pioneer of index funds and founder and former Chairman of the Board of the Vanguard Group, had a brilliant idea for his Princeton University senior thesis. Mr. Bogle was seeking a topic that literally no one had ever written about in a serious academic paper.

While reading an article in Fortune magazine--"Big Money in Boston"--Mr. Bogle stumbled on his topic. The article stated that "mutual funds may look like pretty small change, but constitute a rapidly expanding and somewhat contentious industry that could be of great potential significance to U.S. business."

Among the several main themes resulting from Mr. Bogle's year-and-a-half research and writing of his thesis was his conclusion that "the industry's future growth could be maximized by a reduction of sales loads and management fees." Mr. Bogle's concept was an investment approach that seeks to reduce costs while maintaining performance by matching the investment returns of a specific stock market benchmark, or index.

DOOMED FOR FAILURE?When indexing, an investment manager attempts to replicate the investment results of the target index by buying the securities or a representative sample of the securities. Because this approach would require "passive" investment management, the index could achieve its goal of lowering management fees, trading costs, and other related expenses associated with mutual funds.

In 1974 Mr. Bogle witnessed the birth of the "first" index mutual fund, Vanguard Index Trust. However, until the early 1990s, Mr. Bogle's venture was referred to as "Bogle's Folly" by the experts and the media alike who felt that his idea was doomed from the start.

The reason for the despairing remarks can be attributed to the nature of the mutual fund business. Investors look at mutual funds as a way to make money in the stock market and the acceptance of initiating low cost measures goes to that end. Mutual fund companies exist primarily to make money for their advisers--implying that they should charge the highest costs that traffic will bear. Obviously, the two motives are in conflict with each other.

MAINTAINING PROFITSMutual fund companies equate a winner as a fund that sells while investors equate a winner as a fund that excels. "The industry isn't even trying to assume the high moral ground of putting shareholders first," according to Don Phillips, President of Morningstar Mutual Funds, the Chicago fund rating service. "It's more like, 'How do we maintain our robust 25 percent-or-better profit margin?'"

The average annual cost of owning a general equity mutual fund is 1.44 percent of investor assets. And, since traditional mutual fund managers have high portfolio activity with turnovers as high as 84 percent per year, you need to tack on the added annual cost of 0.5 percent to 1 percent in trading costs. In comparison, index funds' costs start at below 0.2% annually with the average index fund costing 0.45 percent.

NO ADVICE PLEASEMr. Bogle's concept of offering a mutual fund that pays minimal advisory fees, keeps operating expenses at the lowest possible level, and keeps portfolio transactions costs at minimal levels by mirroring a market index flew in the face of standard practice. If no investment advice is needed, then none should be paid for.

Mutual fund companies' reluctance to join in offering index funds has lasted until recently. But, the public is clamoring for more index funds because they want more choices.

In 1976 the industry giant, Fidelity Investments, had poured cold water on the idea of offering an index fund. But in 1990, Fidelity could no longer ignore the tide and was compelled to offer its own index fund, Spartan. However, due to Fidelity's lack of enthusiasm and the $25,000 minimum initial investment, the fund went nowhere. In 1992, Fidelity changed the fund's name and lowered the minimum to $3,000, but it carried a rather high expense ratio of 0.45 percent.

PLAYING THE INDEX GAMEInvestors are no longer naive when it comes to evaluating expense charges. The mutual fund companies entering the index fund market are going to have to embrace Mr. Bogle's frugal management ideas or they will be the ones that are doomed.

Some index funds are actually charging up-front sales commissions or loads. But, according to Mr. Bogle, "...I doubt they'll last. Investors aren't stupid--they'll go for the lower-cost index funds. You either have to play the index-fund game at a low cost or not do it at all."

Today, Mr. Bogle's Folly is recognized as Mr. Bogle's Triumph. The Vanguard Index Trust 500 Portfolio has risen to become the second largest of all U.S. equity funds, managing over $64 billion in assets, and the Vanguard index fund family has more than $394 billion in net assets. As a validation to Mr. Bogle, I am reminded of Stephen Vincent Bent's aphorism, "If the idea is good, it will survive defeat."

In his book, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor, Mr. Bogle shares with the reader the basic principles of mutual fund investing and explores the hype and fads that often lure investors into making unwise decisions.

Next week, let's take a look at the belief, held by many investors, that index funds are a safer way to invest in the market than going through conventional mutual funds. An interesting site to look at is Index Funds Online.

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