“Last year, Vanguard Group raked in $187 million in fees from investors in the Vanguard 500 Index Fund, which in two decades has gone from an object of amusement to the largest mutual fund in the world,” writes Aaron Lucchetti in today’s Wall Street Journal.

“And Standard & Poor’s, the outfit that compiles the now-famous index that the fund tracks? S&P was paid all of $50,000 — the most it can receive annually from Vanguard, in perpetuity, under a license signed when the fund was small.”

“It sounds like the most one-sided deal since the Dutch bought Manhattan for beads. ‘It’s clearly lopsided,’ says Thomas Mench, an investment adviser in Cincinnati specializing in index funds.”

“Now, S&P has struck back. After long pleading futilely with Vanguard for a higher fee, S&P sued the fund firm last year and recently won a round. Though Vanguard’s ability to offer the $90 billion 500 Index Fund isn’t threatened, the fund firm is at least temporarily blocked from building on that huge success by offering certain new products pegged to S&P indexes”

“Increasingly irritated with each other, the two longtime partners uncharacteristically are trading potshots. S&P, a unit of McGraw-Hill Cos., accuses Vanguard in its lawsuit of trying ‘to trample brazenly’ on S&P’s rights. That’s ludicrous, retort Vanguard officials, arguing that S&P should credit the fund company for giving the S&P 500 index priceless publicity. Vanguard Chairman John J. Brennan has described S&P as ungrateful, and Vanguard founder John C. Bogle says, ‘We helped put them on the map.’ “

“That the gray world of index funds could produce such a brawl shows how large and lucrative indexing has become. Index funds hold a basket of securities reflecting some cross section of the financial markets, usually of stocks. Thanks to their strong performance during the 1990s bull market, index funds have become hugely popular. Several million Americans and scores of institutions have an estimated $1.5 trillion invested in hundreds of such funds. They’re now offered by many firms besides Vanguard, and pegged to a number of indexes besides S&P’s. Index funds garnered about $650 million for their managers last year, up fivefold in five years, says Lipper Inc.”

“This is despite index funds’ low fees, relative to actively managed funds. Vanguard owes much of its spectacular growth to its emphasis on rock-bottom fees. Its executives get bonuses for keeping them down. But now, that unwavering focus has put Vanguard on a collision course with S&P, which has set its sights on turning its indexes into a bigger profit center.”

“The feuding poses risks for both. It has soured a relationship that helped propel Vanguard from scrappy maverick to industry giant, with $570 billion in assets, second only to Fidelity Investments’ $896 billion. Says James Pacetti, a mutual-fund consultant, ‘Vanguard is crippled on a major product launch, and S&P is having relationship issues with one of its largest customers.’ “

“Twenty-five years ago, Vanguard’s Mr. Bogle created the first index fund for individuals, based on a simple premise: Since most investment pros couldn’t consistently beat the overall stock market, why not create a fund that simply mirrored the market? He could operate such a fund cheaply, since he wouldn’t have to pick stocks and would rarely need to buy or sell.”

“This passive strategy was initially ignored by most pros and ridiculed by some as defeatist or even un-American. But it made Vanguard a natural ally to S&P, whose decades-old index of 500 large stocks was then little known outside Wall Street. As its indexes gained more of a following, especially among managers of pension-fund money, S&P began demanding a modest fee for creating funds around them. Mr. Bogle reluctantly agreed to a $5,000 annual fee. Then in 1988 he went along with a higher one, capped at $50,000, so that his main mutual fund could add “500” to its name.”

“S&P was happy to make Vanguard a paying client. But over time it realized the deal had a big shortcoming: No matter how much money Vanguard’s fund took in, the fee to S&P wouldn’t budge.”

“By the mid-1990s, the 500 fund’s investment returns were leaving most active money managers in the dust, enticing many individual investors to shift to indexing. Fund companies that once dismissed indexing launched their own index funds. They signed up with S&P or other compilers of market gauges such as Wilshire Associates Inc., Morgan Stanley Capital International, the Frank Russell unit of Northwestern Mutual Life Insurance Co., and Dow Jones & Co., publisher of The Wall Street Journal and the online Journal. They often paid fees that would grow as their funds did.”