John Bogle on Insurance Economics

The Total Stock Market Index Nonetheless, I continue to favor the Wilshire Total U.S. Stock Market Index as the prime benchmark for an index strategy—not to the exclusion of the S&P 500, but as the place to begin for most investors who are not yet indexing. While returns of the two indexes are apt to be identical over the long-run, there seems little to be gained by accepting any short-run deviation from the market. At Vanguard, we began to implement the total market strategy in 1987 with the creation of the industry’s first Extended Market Index Fund, (based on the Wilshire 4500 Index), enabling investors to fill out their S&P 500 portfolios by adding the rest of the market. But, convinced that this two-pronged strategy might someday result in surprisingly high portfolio turnover as stocks moved back and forth between the indexes, in 1992 we introduced the first total stock market index fund, based on the Wilshire 5000 Index. I believe that it is only a matter of time until the total stock market, most easily measured by the Wilshire 5000, becomes the basic standard for the broad-based indexing strategy. The Wisdom of Stock Indexing After more than a quarter of a century of stock indexing, how has it worked? Unbelievably well! Consider the results of Vanguard’s 500 Index Fund since its initial underwriting in 1976. First, it survived, something that can’t be said about 160 of the 356 equity funds in existence when we made our debut.

9. August 31, 1976. The IPO. First Index was off to a bad—near-fatal—start. The initial public offering, led by Wall Street’s four largest retail brokers, was planned for $250 million. It produced $11.3 million, an abject failure. One of the Wall Street managers of that IPO recently asked: “How is it possible that the worst underwriting in Wall Street history became the greatest innovation in modern finance?” Answer: “It’s a long story.” Afterword The poster announcing this CME award for innovation shows photos of me and Mac McQuown—my friend and enormously deserving co-recipient of this award—with the title of this conference: “Taking the Long View and Never Looking Back.” But looking back, as I have done this afternoon, reminds us how fragile the path to an innovation can be, and yet somehow, against all odds, can result in an index fund, and ultimately an Index Revolution. Surely such a tortuous path to success— one that included a university thesis, a catastrophic merger, a firing, a journal article, a novel corporate structure, a fortuitous (perhaps even disingenuous) reading of an agreement, and yes, an unshakable determination—is an extreme example of what it took to turn a great idea into a reality that changed an industry and served investors. That 1976 First Index mutual fund, with its pathetic $11 million in assets, struggled to gain traction. It didn’t attract its first mutual fund competitor until 1984 (Wells Fargo).

substantial (if undisclosed) profits by serving as the broker-dealer for the funds’ portfolio transactions.5 In 1978, this structure, too, was converted into an external manager structure. Since the word “mutual” did not appear in the Investment Company Act of 1940, whence did it arise? I’ve looked through those old Investment Companies manuals published by Arthur Weisenberger & Company all the way back to the 1945 edition, and it is not until that 1949 edition, a quarter-century after the industry began, that I find the first mention of mutual funds. But while the derivation of the term remains a mystery, the paradoxical fact is that it first appears only a short time before the industry began to abandon its early mutual values. History confirms that from the inception of the first U.S. mutual fund in 1924 until the late 1940s, the predominant focus of mutual fund management was on portfolio selection and investment advice, rather than on distribution and marketing. In fact, the managers who founded not only Massachusetts Investors Trust, but State Street Investment Corporation and Incorporated Investors, the original “Big Three” of the fund industry, put themselves forth as “the twentieth-century embodiment of the old Boston trustee.”6 During the industry’s early years, sales of fund shares were often the responsibility of separate underwriting firms financed by distribution revenues from sales loads, and predominately unaffiliated with fund managers.

“Fund independent directors . . . have been absolutely pathetic. They follow a zombie-like process that makes a mockery of stewardship. ‘Independent’ directors, over more than six decades, have failed miserably.” Then, hear this from another investor, one who has not only produced one of the most impressive investment records of the modern era but who has an impeccable reputation for his character and intellectual integrity, David F. Swensen, Chief Investment Officer of Yale University: “The fundamental market failure in the mutual-fund industry involves the interaction between sophisticated, profit-seeking providers of financial services and naïve, return-seeking consumers of investment products. The drive for profits by Wall Street and the mutual-fund 35 It is a curious fact that the operational function was ignored in the 1940 Act. It refers solely to the other two functions of fund management, investment advice and share distribution (underwriting). 36 Toward Common Sense and Common Ground, Journal of Corporation Law (Iowa), Volume 33, Number 1, Fall 2007, Page 1.