In 1975, John Bogle presented an idea to the board of directors of the newly formed Vanguard Group -- create an extremely low-cost mutual fund that would not attempt to beat the returns of the stock market as measured by Standard & Poor's 500 index instead, it would attempt to mirror the index as closely as it could by buying each of the index's 500 stocks in amounts equal to the weightings within the index itself.
In his presentation to the Vanguard board, Bogle presented the historical data then available to him. In his account of The First Index Fund, Bogle writes:
"I projected the costs of managing an index fund to be 0.3% per year in operating expenses and 0.2% per year in transaction costs. Since fund annual costs at that time appeared to be about 2.0%, I concluded that an index fund should reasonably be expected to provide an annual return of +1.5% above a managed fund."
In the intervening years Bogle has proven to be even more correct about indexing than he had predicted he might be. Since then, the gap between the performance of the market and the performance of actively managed mutual funds taken as a whole has actually been significantly wider than the 1.5% theorized by Bogle in 1976. During the 1990s, the total shortfall between actively managed mutual funds and the market as measured by the S&P 500 has so far been a whopping 3.4% per year.
The differential between actively managed funds and passively managed index funds is very easily explicable. The difference does not come from the actively managed mutual funds being run by buffoons. Not at all. The stocks that mutual fund managers pick end up being more or less average performing stocks. Bogle analyzes the differential as being determined by four factors: costs, turnover, sector, and cash reserves.
