Great disappointment often brings great change. In business, the shattering of a long-held belief can create enough clarity and vision that it leads to a great idea and benefits millions. This is what occurred in the 1970s. One man’s epiphany has changed the investment industry forever.
John C. Bogle is the founder and former CEO of the Vanguard Group of mutual funds. In 1976, his firm introduced the first “indexed” mutual fund to track the market’s return. The Vanguard Index Trust, later renamed the Vanguard 500 Index Fund (ticker: VFINX), tracks the performance of the S&P 500 Index benchmark index.
From its humble beginnings in 1976, VFINX has become an icon of success and at one point was the largest US equity mutual fund by asset value. Other index funds and exchange-traded funds (ETFs) spawned from Bogle’s idea. Today index funds and ETFs that track indices account for roughly one-third of equity mutual fund assets.
When you look into the past of any index fund diehard, you’ll often find a sobering story of deep disappointment and financial loss from active management. This period of shock and sorry is followed by an epiphany, an Aha! moment in investing. It occurred in the early 1970s in John Bogle’s case when four active managers that Bogle trusted ending up costing him his job and almost ended his career.
Bogle was a staunch advocate for active fund management early in his career. He was a rising executive at Wellington Management Company in the 1950s and 1960s, a prominent active management firm. Bogle wasn’t a money manager at the firm; rather, he gained a reputation as a keen marketer and administrator.
In 1960, writing as John B. Armstrong in the Financial Analyst Journal, Bogle lauded the benefits of active management and shunned the idea that an unmanaged portfolio of stocks would do better. He wrote this article under the pen name John B. Armstrong because he didn’t want to create a compliance issue for Wellington.
Bogle’s article built a compelling case against passive investing both nominally and on a risk-adjusted basis. In his words, “Leading common stock funds have shown better long-term results than the Dow Jones Industrial Average.” Industry icons were impressed with “The Case for Mutual Fund Management” and awarded Bogle an Honorable Mention in the Graham and Dodd Awards that year.
Bogle rose to prominence at Wellington during the aggressive “Go-Go” years from 1965-1968 in what was labeled as a “New Era” for the stock market. This era was similar to the tech stock boom in the late 1990s that many investors vividly remember. Stocks were driven by illusion rather than fundamentals. Aggressive “performance funds” quickly came to dominate the industry’s focus and cash flows.
Wellington’s fund managers were a conservative bunch and young Bogle wanted more action. He was determined not to let Wellington miss the Go-Go gravy train and he took advantage of his increased stature at the firm to shake things up a bit. During 1966, Bogle engineered a deal that merged Wellington with the Boston investment counseling firm Thorndike, Doran, Paine and Lewis. The Boston firm was managing the hottest Go-Go fund at the time.
The merger worked out well for both firms initially as Go-Go stocks surged. The brilliant young Bogle was promoted to the apex of his career at Wellington as Chief Executive Officer (CEO). He was not yet 40 years old and a Master of the Universe, taking the phrase from Tom Wolfe’s popular book about Wall Street tycoons titled The Bonfires of the Vanities. It wouldn’t last.
By the early 1970s, the Go-Go years blew out and blew over Wellington shareholders, Bogle and the four Boston partners. They developed irreconcilable differences and open hostilities began.
Unfortunately for Bogle, the merger had given the Boston group 40% of Wellington Management's shares to Bogle's 28%. Bogle was ousted as CEO in 1974.
The mark of a strong man is his determination to lift himself up and overcome defeat. After being kicked out of Wellington’s board room, Bogle was able to convince the company to form a new firm that handled back office operations. He also successfully lobbied to run the new entity.
The Vanguard Group was formed in 1975 with Bogle at the helm. It would direct the day-to-day administrative, financial, and legal operations for the Wellington Group of Funds. It would not be allowed to conduct research, manage mutual funds or market them as part of its agreement with Wellington.
Bogle was back in business, but this is just the beginning of the story. Great disappointments often bring about great ideas. Bogle had been gravely hurt by the actions of the four Boston-based active managers and the entire Go-Go era. That led to serious soul searching.
An avid reader, Bogle began to heed the words about unmanaged mutual funds that followed popular indexes. He read about this idea from several people he admired in the media, academia and the investment industry.
John Bogle decided to look more deeply into the growing claims of sub-par active manager returns. There was far more data in 1975 then there was in 1960 when he last studied this information. Bogle calculated by hand the annual returns generated by dozens of actively-managed US equity mutual funds over the previous 30 years. He then compared the performance of each fund with the S&P 500 Index, a broad measure of mostly large US companies.
Bogle’s analysis showed the active funds underperformed the S&P 500 index on an annual pre-tax margin by 1.5 percent. He also found that this shortfall was virtually identical to the costs incurred by fund investors during that period. See The First Index Mutual Fund for Bogle’s own analysis of his study.
That’s when it happened — an epiphany — an Aha moment. A revolution in thinking that was to be the lifelong destiny of Bogle and Vanguard. Bogle realized that others were right - active money management solved the problem of diversification for small investors, but it wasn’t able to keep up with market averages. An index fund, on the other hand, solved both problems.
Although Vanguard was not authorized to manage mutual funds, the agreement with Wellington didn’t preclude the company from running a fund based on the management of others, even if they are members of the Standard and Poor’s Index Committee.
Bogle and his tiny staff went to work creating a proposal for an index fund. They met with Wellington’s board of directors in the fall of 1975 and explained that no advice would be involved in an index fund offering, and that the fund’s underwriting and marketing would be handled by an outside syndicate of brokerage firms so that Vanguard would not be breaking its agreement with Wellington.
The board accepted Bogle’s view and a Declaration of Trust for the Vanguard First Index Investment Trust was filed with the U.S. Securities and Exchange Commission on December 31, 1975. With little fanfare and fewer assets, the official launch of the world’s first index mutual fund occurred on August 31, 1976, according to the Vanguard website.
It grew slowly at first and under close scrutiny. Bogle was ridiculed by the fund industry. But then, aided by a raging bull market that began in 1983, fund assets started an exponential climb. Word spread, and the rest is history.
Fortune interviewed Bogle again in 2007 where he summed up his epiphany, “When I was 38, I became head of Wellington Management, and I did an extremely unwise merger. I got wrapped up in the excitement of the Go-Go era, and the Go-Go era ended. As a result of that stupid decision, I got fired. The great thing about that mistake, which was shameful and inexcusable and a reflection of immaturity and confidence beyond what the facts justified, was that I learned a lot. And if I had not been fired then, there would not have been a Vanguard.”
The investing world thanks you for your mistake, Mr. Bogle.
See more:
