Excerpted from Common Sense on Mutual Funds by John C. Bogle, pages 114-117

I have long believed that it is important to have a sense of history. The history of the index fund serves as a good beginning to understanding its merits. I did not invent the concept of indexing, but I had been a long-time believer in the concept. I was confident that it could - against all odds - become a reality in the world of mutual funds. Not only did it make sense, but it dovetailed with my conviction that low costs truly make a difference - if not the difference - in emulating the returns available in financial markets. As I have noted, history tells us that doing so is hardly a modest goal for the long-term investor.

The pioneers of the indexing concept were William Fouse and John McQuown of Wells Fargo Bank. During 1969-1971, they had worked from academic models to develop the principles and techniques that led to index investing. Their efforts resulted in the construction of a $6 million index account for the pension fund of Samsonite Corporation, with a strategy based on an equal-weighted index of all equities listed on the New York Stock Exchange. Fouse described its execution as a "nightmare." The strategy was abandoned in 1976 and was replaced with a market-weighted strategy using the Standard & Poor's 500 Composite Stock Price Index. The first accounts run by Wells Fargo were components of its own pension fund and that of Illinois Bell Telephone Corporation.

Slightly later in 1971, Batterymarch Financial Management of Boston decided independently to pursue the idea of index investing. The developers were Jeremy Grantham and Dean LeBaron, two of the founders of the firm. Grantham described the idea at a Harvard Business School seminar in 1971, but found no takers until 1973. For its efforts, Batterymarch won the "Dubious Achievement Award" from Pensions & Investments magazine in 1972. Two years later, in December 1974, the firm finally attracted its first index client.

In 1974, the American National Bank in Chicago created a common trust fund modeled on the S&P 500 Index. A minimum investment of $100,000 was required. By that time, the idea had begun to spread from academia, and from three firms that were the first professional believers, to a public forum. Gradually, the press began to comment on index investing. A cri de coeur calling for the creation of index funds came from three remarkably intelligent and farsighted observers. I still treasure their articles, which inspired me nearly 25 years ago and read just as well today.

"Challenge to Judgment"

The first article was "Challenge to Judgment," by Paul A. Samuelson, Professor of Finance at the Massachusetts Institute of Technology, and a Nobel Laureate in economics. In The Journal of Portfolio Management (Fall 1974), he pleaded "that, at the least, some large foundation set up an in-house portfolio that tracks S&P 500 Index - if only for the purpose of setting up a naïve model against which their in-house gunslingers can measure their prowess.... Perhaps CREF (College Retirement Equities Fund) can be induced to set-up a pilot-plant operation of an unmanaged diversified fund, but I would not bet on it ... [or] the American Economic Association might contemplate setting-up for its members a no-load, no management fee, virtually no transaction-turnover fund. He noted, however, what might be an insurmountable difficulty: that there may be less supernumerary wealth to be found among 20,000 economists [to provide capital for the fund] than among 20,000 chiropractors."

Dr. Samuelson concluded his challenge by calling on those who disagreed that a passive index would outperform most active managers to dispose of that uncomfortable brute fact (that it is virtually impossible for academics with access to public records to identify any consistently excellent performers) in the only way that any fact is disposed of - by producing brute evidence to the contrary. There is no record that anyone tried to produce such evidence, nor is it likely that it could have been produced. But Dr. Samuelson had laid down an implicit challenge for somebody, somewhere to launch an index fund.

"The Loser's Game"

A year later, Charles D. Ellis, Managing Partner of Greenwich Associates, wrote a seminal article entitled "The Loser's Game" in the Financial Analysts Journal (July/August 1975). Ellis proffered a provocative and bold statement: "The investment management business is built upon a simple and basic belief: professional managers can beat the market. The premise appears to be false." He pointed out that, over the preceding decade, 85 percent of institutional investors had underperformed the return of the S&P 500, largely because, in an environment in which institutional investors have become, and will continue to be, the dominant feature of their own environment, the costs of institutional investing have consumed 20 percent of the returns earned by the managers, "causing the transformation that took money management from a Winner's Game to a Loser's Game. The ultimate outcome is determined by who can lose the fewest points, not who can win them." He went on to note that "gambling in a casino where the house takes 20 percent of every pot is obviously a Loser's Game ... so money management has become a Loser's Game."

Ellis did not call for the formation of an index fund, but he did ask: "Does the index necessarily lead to an entirely passive index portfolio?" He answered, "No, it doesn't necessarily lead in that direction. Not quite. But if you can't beat the market, you should certainly consider joining it. An index fund is one way." In the real world, of course, few managers indeed have consistently succeeded in achieving an annual return sufficient even to offset their costs and thereby match the index, let alone surpass it. Even those few have been exceptionally difficult to identify in advance.

"Fortune Leads to a Flood Tide"

"There is a tide in the affairs of men, which taken at the flood, leads to fortune." Shakespeare put those words in Brutus's mouth. Ironically, in the field of index funds, fortune, in a sense, helped turn the tide of investment affairs toward index funds. In July 1975, Fortune magazine published a third landmark article. "Some Kinds of Mutual Funds Make Sense," was written by Associate Editor A. F. Ehrbar. Ehrbar came to some conclusions that may seem obvious today, but were then hardly the accepted wisdom: "While funds cannot consistently outperform the market, they can consistently underperform it by generating excessive research (i.e., management fees) and trading costs ... it is clear that prospective buyers of mutual funds should look over the costs before making any decisions." He concluded, "Funds actually do worse than the market."

Ehrbar despaired that an index mutual fund would be created very soon, noting that "there has not been much pioneering lately and the mutual-fund industry has not provided an index fund." But he described the best alternative for mutual fund investors: "A no-load mutual fund with low expenses and management fees, about the same degree of risk as the market as a whole, and a policy of always being fully invested." He could not have realized that he had described, with some accuracy, the first index mutual fund, which was soon to be formed. But that is what he had done.

"Opportunity Is the Mother of Invention"

Together, these three clarion calls for an index mutual fund were irresistible. I could no longer contain my enthusiasm for the opportunity to be in the vanguard, as it were, of the development of the index fund. Based on my research on past fund performance, well known in academia but acknowledged by few in the investing profession, I was confident it would work. Further, the firm I had founded in 1974 was focused on low cost, precisely the key to having an index fund that would emulate a cost-free index. It was the opportunity of a lifetime: to prove that the basic theory enunciated in these articles could be put into practice and made to work in a real-world framework. Alas, there was no demand for it by the investing public. So I relied on Say's Law (after French economist Jean Baptiste Say): "Supply creates its own demand." Before 1975 came to its close, Vanguard had created the first index mutual fund, modeled on the Standard & Poor's 500 Composite Stock Price Index.