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A Brief History of Index Fund and Passive Investing

The idea of implementing a passive or index fund approach to investing originated with academic work that was pioneered at the intersection of economics, finance, and technology.  The original underpinnings were introduced in the 1960s under the label of market efficiency and later modern portfolio theory.  It is not purely coincidence that these insights occurred when they did.  The commercialization of increasingly powerful computing technology in the 1950s and 1960s,  enabled researchers to more efficiently detect significant patterns based on decades of empirical asset price data.  

To summarize the key aspects of the academic work, researchers studying data regarding stock price movements and investment returns achieved by market participants realized that in the short-term predicting the prices of investment assets in liquid public trading markets was extremely difficult (even impossible).  They also realized that in the aggregate, markets do a reasonable job of pricing investment assets based on the information available at hand. 

Based on these observations and several additional simplifying assumptions (later academic work demonstrated that these assumptions were probably oversimplifications - having important implications for why enhanced indexing today may be a superior approach), they realized that the vast majority of investors do not manage to beat the market averages over the long-run.  Specifically, over 10 year periods, as many as 75 to 80% of all funds and investors who try to beat the market fail to do so.  While this means that 20 to 25% of professional investors do beat the market, most investors find it difficult or impossible to identify who the winners will be upfront.

Given that most investors think that they will be the exception to the rule and since these academic conclusions seemed counterintuitive in light of hundreds of years of conventional wisdom, most investors and professional advisors at the time implemented only "active" management investment approaches.  Active management involves doing research or paying advisors to pick investments to try and beat the market.  Of course, doing so involves expenditure of time and resources and investors collectively pay to support all this activity.

In an if-you-can't-beat-them-join-them realization, the academic work implied that many investors might be better off to admit that their odds of beating the market are low.  Instead of playing this loser's game, they would be better served by vehicles that would allow them to enjoy performance similar to the market averages (we say similar to because any approach has some cost associated with implementation) and at a lower cost.  Since the market components do not change that frequently, this type of "market indexed" portfolio would also feature relatively low amounts of trading and high tax-efficiency.  In essence, indexing is a buy-and-hold approach where the companies held are those representative of the market as a whole (and later to include certain sub-segments as well). 

While index fund vehicles like this did not exist, by and large, in the 1960s, several firms began offering institutional investors (and later individual investors) index fund options that offered to replicate the broader market beginning in the early to mid-1970s.  Most notably, John Bogle, started Vanguard to offer this sensible index-based approach to individuals through lower cost mutual funds.  Due mostly to its merits, index funds investing (also called passive investing) really caught on in the next few decades.

The early index funds were based on widely known and followed market averages or indexes, most notably the S&P500.  S&P stands for Standard & Poor's, the financial rating and research firm based in New York City.  The origins of the S&P500 begin as early as 1923 with 233 companies in 26 industries.  In the modern version, there are 500 companies which are selected to represent the major components of the economy and the stock market.  Each company in the index is assigned a weight (based on its size).  An index fund tracking the S&P500, for example, would attempt to simply own these 500 companies in the proportions necessary to match this index as closely as possible.

Remember, an index fund does not try to beat the market, but only replicate the market though a diversified ownership of hundreds or thousands of companies that are part of the index that the fund is seeking to replicate.  This focus on tracking instead of beating/performing is an important jumping off point in our later discussion of enhanced indexing.

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