Nowadays, index fund investing is one of the most popular and reliable ways to grow your
wealth over the long term.
And given the high diversification, the low volatility, and the extreme ease of index
funds, it’s no wonder they’re so popular.
But index funds aren’t a classic investment tool like you might think.
Just 30 years ago, index funds were largely avoided, and 50 years ago, index fund investing
wasn’t even a thing.
It wasn’t until 1972 that the world’s first index fund was created.
Vanguard entered the scene a few years later in 1975, and since then they’ve grown to
be the king of index funds.
The largest index fund today is actually the SPDR SPY ETF, but this is more of an anomaly.
If you look right below Spy, you’ll see that 5 out of the top 10 funds are from Vanguard
and that 31 out of the top 100 funds are also from Vanguard.
So, here’s how Vanguard became the second largest investment firm in the world by just
embracing average.
It all started with a man named John C Bogle who was born on May 8, 1929 right before the
great depression started.
John’s family, unfortunately, got annihilated by the great depression.
His parents lost all of their savings and they were forced to sell their house.
John’s father basically gave up on life and became an alcoholic which resulted in
John’s parents divorcing.
So, from a very young age, John was on his own and his clearest path to success was education.
John and his twin brother David both worked extremely hard at school to try to get ahead,
and this would end up paying off.
John’s stellar academic record earned him a spot at an elite boarding school named Blair
Academy on a full-ride work scholarship.
Today, Blair Academy charges $66,500 per year and they only have a total of 462 students.
So, I think it’s safe to assume that they don’t give these spots very easily.
Anyway, John continued to excel at Blair and he would eventually get accepted into Princeton.
At Princeton, John majored in economics and investments and it didn’t take him long
to delve into the world of mutual funds.
During his junior and senior years in college, John wrote a graduating thesis paper called
“The Economic Role of the Investment Company”.
This paper would actually get John his first job.
The story goes that Walter L Morgan, the founder of the Wellington fund read John’s 130-page
paper and that he hired John right after.
John quickly became a star at the fund and by 1955, John was promoted to being an assistant
manager of the fund.
John also pushed for the creation of a new fund that was less concentrated than Wellington’s
other funds.
Eventually, John would get his way and this new fund turned out to be a great success.
Soon enough, Walter Morgan would retire from the company in 1970 and he would choose John
to be his successor.
Things were going phenomenally for John.
He had become the leader of a well-respected fund at a rather young age of 41 years old.
But, unfortunately, John would make a fateful decision that would get him ousted from the
company.
In the 1970s, John approved a merger that turned out to be a disaster, and John would
be fired soon after.
Though this was likely a terrible experience, what’s surprising is that John never complained
about it or tried to make excuses.
In fact, he describes the mistake as quote “shameful and inexcusable and a reflection
of immaturity and confidence beyond what the facts justified.”
It’s crazy how down to earth and humble John was despite all of his success.
John decided to start his own investment firm named Vanguard in 1974 and that brings us
to the creation of the index fund.
John is often credited with inventing the world’s first index fund, but this isn’t
actually the case.
The first idea for an index funds dates back to two University of Chicago students.
Edward Renshaw and Paul Feldstein suggested the idea of creating an unmanaged investment
company way back in 1960, but the idea barely got any support and it didn’t go anywhere.
A decade later though, a company named Qualidex Fund Inc would make their vision a reality
by creating a fund that tracked the Dow Jones Industrial Average on July 31, 1972.
So, John was not the first to create an index fund, but he’s still no doubt the father
of index fund investing given that he was the one to popularize it.
John launched Vanguard’s first index fund called the First Index Investment Trust on
December 31, 1975.
The success of Vanguard didn’t just happen overnight though because there was a massive
problem.
In the 1970s, there was very little respect for index fund investing within wall street.
Fund managers thought that the idea of index funds was whimsical and utterly pointless.
It wasn’t just fund managers saying this either, most investors held a similar belief
due to 2 key reasons.
First of all, investors felt that they could just do it themselves if they wanted to.
All an index fund is doing is splitting the money you invest across dozens or hundreds
of companies depending on what the fund is tracking.
Investors could easily just do that themselves.
They could call up their brokerage and tell them to split their money across Nasdaq stocks
or S&P 500 stocks.
The investor wouldn’t even have to go through the tediousness of buying 500 different stocks,
that was the brokerages’ problem.
The second argument against index funds was that it was quote and quote unamerican and
counterintuitive.
People invest with fund managers to beat the market, not to match the market.
This is why the chairman of Fidelity Edward Johnson said that he couldn’t believe that
the great mass of investors would be satisfied with receiving just average returns.
And these fund managers were right about Vanguard at least at the start.
The launch of the First Index Investment Trust was a massive disappointment.
John was hoping to raise $150 million during the IPO but they only ended up raising a measly
$11 million.
Now, you might be thinking $11 million isn’t that bad.
But the thing to keep in mind is that Vanguard is just a manager of assets which means that
they’re only paid a very small percentage of what they manage.
Even if they charged 1% which is super high for a passive fund, they would only make $110,000
per year.
And that money isn’t just for John, that money needs to support the operations of the
entire company.
Fortunately, Vanguard was just a group of three people including John and two analysts,
so the overhead costs were that large.
Nonetheless, the IPO was extremely disappointing.
The banks that helped John complete the IPO advised that he should shut down the fund
given the poor reception, but John refused.
John strongly believed that index fund investing would become more popular for two of his own
reasons.
His first argument was that the fees of an index fund just had to be low enough for it
to be worth investors’ time.
The S&P 500 adds companies and kicks out companies on a quarterly basis.
So, if you’re trying to track the S&P 500 on your own, you would have to rebalance your
portfolio every quarter.
Also, every time you wanted to add money in or take money out of your portfolio, you would
have to buy or sell the stocks of 500 different companies.
And whether it’s the investor doing it or the broker doing it on behalf of the investor,
someone has to spend the time and money to accurately track the desired index.
If you were able to offer this service for a silly low price, investors and brokers may
very well be interested.
Since the start of Vanguard, one of the key characteristics has been their stupid low
fees.
The annual fee on their S&P 500 fund VOO for instance is only 0.03% per year.
This means that for every $10,000 you invest, Vanguard only charges $3 per year.
I think you can see why this is quite attractive.
John’s second belief was that over the long term, actively managed funds would lose to
the market.
And over time, we’ve seen that this is indeed the case with most funds.
But in the late 1970s, John’s low fees and long-term outlook weren’t very convincing.
At the end of the first year, the index fund had only grown to $17 million.
But eventually, when the bull market started in 1982 after the inflation crisis of the
1970s, the indices finally started to grow at a substantial rate.
This significantly boosted the interest in index fund investing, but index funds were
still largely avoided.
Something that did help Vanguard though was the start of the 401k era in the 1908s.
Instead of directly targeting investors and brokerages with their index funds, Vanguard
switched its focus to companies.
Unlike investors and wall street who were concerned about beating the market and generating
the greatest returns possible, companies were more concerned about giving their employees
a low-cost, reliable, and stable investment option, and index funds were perfect for this.
Vanguard became a top choice for employee retirement funds and 401k plans which allowed
Vanguard to finally gain some traction.
Vanguard didn’t stop targeting direct investors either though.
They actually came out with more options for direct investors.
In December of 1986, Vanguard launched their second fund which was the Total Bond Fund.
In December of 1987, Vanguard launched the extended market index fund which tracks the
entire stock market.
Since then, Vanguard has continuously launched fund after fund each with a different focus
such as small market cap companies and commodities.
All of these new funds combined with the rise of retirement funds, Vanguard blew up during
the 1980s and they ended the decade with $55.8 billion in assets under management.
For most funds, this would be a fantastic amount but given Vanguard’s extremely low
fee structure, they needed much more to make the same amount of money as a regular $55.8
billion funds.
With a 0.03% fee, for instance, Vanguard would only be pulling in $16.7 million per year
despite managing $55.8 billion.
Fortunately, though, Vanguard’s assets would continue to grow exponentially throughout
the 1990s.
The key development in the 1990s and early 2000s was the rise of tech companies and the
dot-com bubble.
Tech companies paid their employees extremely well which made managing their retirements
funds extremely lucrative.
By 2005, Vanguard’s assets under management grew to just under $1 trillion.
In the meantime, John retired from Vanguard in 1999 as he reached the mandatory retirement
age at the company of 70.
Since John’s retirement, the new leaders of Vanguard have placed more focus on actively
managed funds, but ironically, this is when the popularity of index funds went through
the roof.
In the late 2000s, Warren Buffett made his famous bet against hedge funds, and retail
investors have been more than happy to take it easy and simply enjoy market returns.
This newfound retail interest has skyrocketed Vanguard’s total assets under management
to a whopping $7.5 trillion.
But what I think is even more impressive than their crazy balance sheet is their ethics.
Wall Street often gets a bad rep for terrible ethics and most of the criticism they get
is well deserved.
But the same cannot be said about Vanguard.
The only profit Vanguard makes is the measly fees they charge on their funds.
Now, of course, they manage trillions, so they make plenty of money.
But what I’m referring to is the fact that Vanguard doesn’t actually have any investors.
John strongly believed that it was a major conflict of interest to offer stock in a company
that was meant to generate the best returns possible for their fund investors.
Every dollar the company makes is one less dollar that could’ve been paid out to the
fund investors.
So, John decided that Vanguard would have no ownership whatsoever.
Vanguard doesn’t have any stock and it’s not privately owned.
Instead, Vanguard likes to say that the company is owned by all the investors of their funds.
To put in perspective how much Vanguard is giving up with this decision, let’s take
a look at Blackrock.
Blackrock is the largest asset manager in the world and they manage over $9 trillion
worth of assets.
Blackrock does have stock and its market cap is $138 billion.
Even if we said that Vanguard was only valued half as much as Blackrock, that would be about
$70 billion.
John could’ve easily held onto 25% of the company which would’ve given him a net worth
of $17.5 billion.
But instead, John died with a net worth of only $80 million.
Obviously, that’s not a bad amount, but for someone who literally created trillions
of dollars of value for American investors, that’s an awfully modest salary.
Something else I wanted to note is that John gave half of his salary to charity.
Truly quite an inspiring story, but we’ll have to see how long Vanguard upholds John’s
ethics because John, unfortunately, passed away 2 years ago in 2019.
I’m sure his legacy with Vanguard, however, will live on forever.
What do you guys think about Vanguard’s business model?
Comment that down below.
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