An index is a theoretical “basket” of securities designed to represent a broad market or a portion of the market. By reflecting the performance of a particular market, an index provides investors with a benchmark for that market’s performance. Because indexes are, by definition, intended to mirror the market, they are constructed to be market capitalization weighted. An indexed investment strategy such as an index mutual fund or an index-based exchange-traded fund seeks to track the performance of an index by assembling a portfolio that invests in the same group of securities, or a sampling of the securities, that compose the index. By investing in a product designed to replicate the performance of a broad market such as the U.S. stock market, an investor can participate, at low cost, in the aggregate performance of that market at all times. By the same token, investing in products designed to replicate the performance of indexes with a narrower focus, such as European stocks or long-term bonds, allows an investor to participate in the purest exposure to a specific market segment within a low-cost framework. As a result of these features, indexing has gained in popularity over time. Estimates of index fund assets, including ETFs, are as high as $2.008 trillion, or 16.9 percent of the total assets managed by registered investment companies.1
Historically over time, an indexing investment strategy has performed favorably in relation to actively managed investment strategies, as a result of indexing’s low costs, broad diversification, minimal cash drag, and, for taxable investors, the potential for tax efficiency. Combined, these factors represent a significant hurdle that an active manager must overcome just to break even with a low-cost index strategy over time, in any market. Of course, skilled active managers who have overcome these hurdles do exist, but as our research and other empirical evidence suggest, the likelihood of outperformance by a majority of managers dwindles over time as the compounding of costs becomes more difficult to surmount.
This paper explores both the theory underlying index investing and evidence to support its advantages. We first examine investing as a “zero-sum game” and relate it to the “index funds versus active funds” debate. We emphasize the importance of costs in investment management and their impact on index and active strategies. We then offer a broader perspective on relative performance, including subasset classes, market cyclicality, and benchmark differences. We discuss, as well, excess returns as an alternate perspective on relative success. Finally, we address common myths regarding indexing as an investment strategy.
Understanding The Zero-Sum Game
An investment in conventional or exchange-traded index funds (hereafter, “index funds”) seeks to track the returns of that market or market segment by assembling a portfolio that invests in the same group of securities, or a sampling of the securities, that compose the market with weights proportionate to their market value. Indexing uses quantitative risk-control techniques that seek to replicate the benchmark’s return with minimal expected tracking error (and, by extension, with no expected alpha, or excess return versus the benchmark).2 In fact, the best index is not necessarily the one that provides the highest return, but the one that most accurately measures the performance of the investing style strategy or market it is intended to track.