AS INCREDIBLE AS

it might have seemed last January, the major stock indexes are shaping up to post losses for a third consecutive year in 2002. That, of course, means the index mutual funds that track them are underwater, too.

Managers of actively managed funds point to the positive returns of some funds this year as evidence that the concept of indexing, so popular in the 1990s, is flawed. And perhaps they have a point. Indexing can lock investors into owning dreadful stocks like Tyco International, for instance that they simply might not want to hold. In nasty bear markets rocked by indiscriminate selling, this seems like a major problem.

SmartMoney.com decided to ask John Bogle, the man whose name is synonymous with index funds, if he's ready to concede defeat. Not surprisingly, the answer was a resounding "No." Bogle, who founded the Vanguard Group in 1974, launched the first index fund a year later. Based on the Standard & Poor's 500 index, the fund initially known as the First Index Investment Trust has morphed into the colossal Vanguard 500 Index fund, becoming the biggest fund in the world in 2000. (After falling behind the Pimco Total Return fund for a short while this year, it regained the title.)

Although the Vanguard family offers some actively managed funds, it's known mostly for its big stable of index funds, covering virtually every corner of the equity and bond markets.

After retiring as Vanguard's chairman in 1996, the outspoken industry leader created the Bogle Financial Market Research Center, which is essentially his personal soapbox. He travels the country lecturing on what's needed to restore faith in the stock market and improve the mutual-fund business. He's also a member of the Conference Board's Blue Ribbon Commission on Public Trust and Enterprise with former Securities and Exchange Commission Chairman Arthur Levitt, among others.

SmartMoney.com: Do you still think index funds are better than managed funds? Is there historical evidence to support this view?

John Bogle: I think index funds are unequivocally the best way to invest. It's some kind of fiscal dalliance to say they have been badly beaten. Two facts from 2002: It's the worst market decline in a long, long time, since 1973-74. But the Vanguard Total Stock Market Index is at this moment outperforming 75% of all large-cap mutual funds, and the 500 Index Fund is outperforming 66% of all large-cap funds. If that's a bad year, I can't wait for a good one.

The reality is that indexing always wins. If you understand the simple fact that, everyday, all investors as a group constitute the market, then beating the market is a zero-sum game. But only before costs are deducted. If you [add up] the costs of financial remediation, managers, brokers and such, it's something like $400 billion a year. We know mutual funds alone have $120 billion in [aggregate annual] costs: $70 billion in fees, $40 billion in transaction costs and $10 billion in commissions. It does no violence to the system to believe $400 billion to $500 billion is the amount of costs all investors lose to the market.

So beating the market goes from a zero-sum game without costs to a loser's game when you take costs out. There's no way around it. If costs are low, index funds will always beat managed funds.

SM: When the financial system shows itself to be rife with corruption, as it has in the past two years, index funds make it impossible for investors to get out of obviously bad stocks. Given the inherent limitations of passive investing, why, in your view, does the model still work?

JB: The reason the model works is the active manager. It would probably come out that index funds owned a total of 10% of Enron and other investors owned 90%. And they sold to other investors in the market, who were happy to buy. I didn't see any evidence of a massive sell-off in Enron. In fact, I saw highly regarded investors buying Enron on the way down. As a group, if the index owns 10%, then someone else owns 90%. For instance, the active funds owned far more technology than the index funds did, because they created all these tech funds. When you realize each purchase involves a sale and each transaction involves a cost, you have to wonder where all the witchcraft is that says the active managers can win. The record is bereft of any evidence that active managers win.

SM: Where do you see the stock market a year to 18 months from now?

JB: Nobody has any clue where the market will be in 18 months. They are guessing at the emotions and the price/earnings multiple that the market will have, and how anybody can do that is beyond me. Market returns come from two simple sources: One is investment or economic return, which includes dividends. Right now, the average dividend yield is about 2%, and future earnings growth has been estimated at about 6%. So we're expecting an 8% investment return in the years ahead, assuming average corporate profit growth. And long-term records show that corporate profits grow at the same rate as gross domestic product.

The other part of return is speculative or emotional return. Right now the market is selling at about 16 times earnings. If 10 years from now it is still selling at 16 times, then the speculative return will be zero. I think that could go up. The long-term norm is 15, but I think it could go up to 18, it's a guess, but it's a 12% increase from 16 times, and that, spread over 10 years, would be another percentage point or two of speculative returns. Therefore the combination would give you stock returns of 9% or 10% a year. So a realistic and reasonable expectation would be for future stock returns of between 6% and 10%. That's what I would use for planning purposes. The one thing we are certain of is it won't be 8%, 8%, 8%, 8%, each year. Whether it goes down or comes back, who knows? Nobody knows, and it's extremely unwise to forecast.

SM: Which asset classes do you think will lead the market during the next economic recovery real estate, bonds or stocks? Which will do best over the next five years?

JB: I think stocks will be the biggest performing assets over the next 10 years. We can have reasonable expectations of 8% or 9%, and we also know a lot about forecasting bond returns. An excellent, or very nearly perfect, way to view bond returns is to look at the current interest rate. The correlation with today's interest rate and the return over the next decade is 0.9. The interest rates of governments and corporates average 5.5%. It follows that the returns should be 4% to 7% over the next 10 years, but more likely 5.5%. So it looks like stocks will do better than bonds. Real estate? Who knows? We are in what appears to be a real-estate bubble, and it's been good for two or three years in real-estate funds and stocks. I'm a great believer in reversion to the mean that is, what goes up must come down, or Sir Isaac Newton's revenge on Wall Street.

SM: What regulatory changes would you like to see on Wall Street and in corporate America?

JB: I think from a regulatory standpoint we have done just about all we can do, unfortunately. Although I do think that we need a lot of changes within the system. Our corporate officers and fund managers and institutional investors should think more long term, but I don't know how to regulate that. The average mutual fund holds the average stock for an average of 11 months. That's short-term speculation, which has nothing to do with long-term investing.

One thing we could do is raise taxes on short-term capital gains sharply. And sharply reduce them on stocks held more than five years. I also think it's time to give a little dividend tax relief. I think we should be looking at giving every American citizen tax relief on the first $500 to $1,000 of dividends they receive. That would go a long way to reducing double taxation.

SM: What do you think needs to be changed in the mutual-fund industry?

JB: We need to act like investors instead of traders get out of the rent-a-stock industry. I would like fees to come down and portfolio turnover to come down. I'd like the specialty portfolios to cease and desist and I'd like the business of jumping onto trend bandwagons eliminated. And I have no objection to eliminating performance-based advertising.