Forty years after their invention, index funds are starting to get their due.

What is an Index?

When we speak of the stock market, it’s useful to have models to know exactly what we’re describing. The United States has approximately 6,000 publicly traded companies. Investors regularly describe the market by referring to an index, like, for example, the Standard & Poor’s (S&P) 500.  The S&P 500 consists of 500 of the largest public companies and represents roughly 80% of the total value of the U.S. stock market. Yes, 80% of the market is the largest 500 companies. The largest company (Apple) represents  around 4% of the U.S. stock market value all by itself.

Beating an Index is Hard to Do

Observers who track market performance note the difficulty of beating the returns of the total market itself. Vanguard Group founder John Bogle calls this “the relentless rule of humble arithmetic.” Put simply: the return of the total market must equal the average return of all investors. To the extent someone gets more return, someone else must get less. It’s a zero-sum game.

Every year some managers would beat the market of course, but their identities change unpredictably. You know how ads for mutual funds always include the disclaimer that “past performance is not indicative of future results”? It’s absolutely true. Reading the tea leaves (or mutual fund results) from prior years tells investors nothing about what’s going to happen in the next month or year.

Enter the Index Mutual Fund

Academics (particularly at the University of Chicago) theorized that an individual investor should be able to buy the entire market efficiently and inexpensively. With the development of powerful new computers in the 1970s (probably weaker than your iPhone today), these ideas slowly became reality.

It was not until the mid-1970s that an index fund became available to retail investors. In 1976 the little-known Vanguard Group turned on the lights and opened the Vanguard 500 Index fund. Its premise echoed the academic theories. If it was impossible to beat the financial markets, shouldn’t an investor be able to buy the entire market? Wouldn’t an investor like to get the market average every year (at low cost) without fail?

Warning: Math Approaching

Running an index fund was certainly cheaper than running a traditional managed fund. No expensive managers or analysts, no expensive research, and no excessive costs. Expenses include actual trading costs, plus the administration of running a fund: sending statements, handling cash flows, etc. From the beginning, index fund investors enjoyed an advantage over managed funds through their lower costs of operation.

The difference between the fund‘s return rate and the investor‘s return rate is critical.  Investors in mutual funds do not get the same returns as the fund. They get the fund’s return minus the fund’s expenses. This is where the index fund shines. In a good year the S&P 500 may return 10%. A typical index investor (paying 0.1%) would get 9.9%. The investor in a managed fund that charges 0.8% would receive 9.2%. It may not seem like much in one year, but watch what happens with the magic of compound math. After twenty years our index investor would grow $10,000 into $66,000, while our managed fund investor would grow her $10,000 to $58,000.

A New World: Index Funds for Everyone

Vanguard’s idea has spread in the forty years since its inception. Investors can now find hundreds of passively-oriented funds tracking indexes. You can find index funds for everything: large company stocks, real estate, foreign companies. Virtually any other investment you care to name probably has an index fund. Index funds also exist for fixed income investments (bonds) that enjoy a better cost structure, adding to your bottom line.

While hardly an overnight sensation, index fund use has grown dramatically. It now accounts for almost 40% of assets invested in mutual funds and exchange traded funds (ETFs). A new generation of investor has realized the powerful advantage of harnessing the power of the market at low cost.