The idea of an index fund was first presented to the board of directors of the newly formed Vanguard Group by John Bogle. He outlined the creation of a low-cost mutual fund that would not try to beat the returns of the stock market and would instead attempt to mirror the Standard & Poor’s 500 index as closely as possible by buying each of the index’s stocks in amounts equal to the weightings they have within the index. He projected the annual costs of managing such a fund to be around 0.3% in operating expenses and 0.2% in transaction costs and concluded that an index fund can be expected to outperform a regular actively managed fund by 1.5%. In fact, in the 1990s, the S&P 500 has beaten the average diversified mutual fund by 3.4%, providing an annualized return of 17.3%, and the reasons are as follows:

• The costs of passive management are way lower than those of the funds where managers have to map out strategy and maintain it. Expense ratios now average 1.5% at actively traded funds as opposed to 0.19% at Vanguard S&P 500.

• In mutual funds that frequently trade in stocks annual turnover reaches 85% of stock. It means that a big slice of return disappears due to frequent trades.

• Hand-picking assets does not always yield a better return than the one given by the market in general. It takes a really smart fund manager to outperform S&P500 that over the 1990s consistently showed better results than those of the market in general.

• Fund managers typically hold approximately 8% of their portfolios in cash reserves for additional investments in the hope for timing the market. This practice proves costly in the bullish market.

• Expense ratio of the average fund, that is the average amount of expenses that a fund charges its shareholders every year, was about 1.3% during the period. The Vanguard S&P 500 expense ratio is 0.19%.