Swedroe: Why Index Investing Wins

December 28, 2015

J.B. Heaton, Nick Polson and J.H. Witte recently authored a nice short paper—it’s all of four pages—entitled “Why Indexing Works.” In it, the authors developed a simple stock selection model to explain why active equity fund managers tend to underperform their benchmark index.

While most of the academic literature focuses on the efficiency of the market and the higher costs of active management, Heaton, Polson and Witte focus their attention on another aspect of active management’s costs.

They show the much higher “cost” of active management may be the inherently high chance of underperformance that comes with the attempt to select stocks, since stock selection disproportionately increases the chance of underperformance relative to the chance of outperformance.

Just A Few Winners Needed

Heaton, Polson and Witte, whose paper was published in October 2015, develop a simple model that builds on the underemphasized empirical fact that the best-performing stocks in a broad index perform much better than the other stocks in that index. In other words, average index returns depend heavily on the relatively small set of winners.

In their stock selection model, the authors randomly select a small subset of securities from an index and found that doing so maximizes the chance of outperforming the index—the allure of active equity management—but it also maximizes the chance of underperforming the index, with the chance of underperformance being larger than the chance of outperformance.

Underperformance More Likely

They also found that “the risk of substantial index underperformance always dominates the chance of substantial index outperformance, with the difference being greater the smaller the size of the selected sub-portfolios.”

The authors write: “It is far more likely that a randomly selected subset of the 500 stocks will underperform than overperform, because average index performance depends on the inclusion of the extreme winners that often are missed in sub-portfolios.”

Last year provided the perfect example of what Heaton, Polson and Witte found in their testing. While the S&P 500 Index returned 13.7% overall, there were 10 stocks in it that returned at least 62.4%. This type of performance isn’t unusual. Let’s look at some of the historical evidence regarding the risk-adjusted odds of outperformance.

How Have Investors Been Served?

Robert Arnott, Andrew Berkin and Jia Ye—authors of the study, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?”, which was published in the Summer 2000 issue of The Journal of Portfolio Management—found:

  • The average actively managed fund underperformed its benchmark by 1.75% per year before taxes, and by 2.58% per year on an after-tax basis.
  • Just 22% of funds beat their benchmark on a pretax basis. The average outperformance was 1.4%; the average underperformance was 2.6% (which is consistent with the finding from Heaton, Polson and Witte that the risk of substantial index underperformance dominates the chance of substantial index outperformance). However, on an after-tax basis, just 14% of funds outperformed. The average after-tax outperformance was 1.3%; the average after-tax underperformance was 3.2%. Thus, the risk-adjusted odds against outperformance are about 17:1.

In addition, they found that the odds of outperforming were about twice as bad when returns were examined on an after-tax basis, as there were about 11 times as many losers as winners.

It’s also important to note that this study covered a period when about 20% of active managers were delivering statistically significant alpha. As Andrew Berkin and I show in our new book, “The Incredible Shrinking Alpha,” that figure has shrunk to about 2%. And even these abysmal odds understate the issue. Here’s why …

More Funds, More Underperformance

Since diversification of risk across asset classes is an important part of a prudent investment plan, most investors build portfolios using a variety of funds to provide them with their desired exposure to a wide range of asset classes. Research has found that the odds a portfolio of actively managed funds will outperform decrease as you increase the number of funds in that portfolio.

Richard Ferri and Alex Benke—authors of the study “A Case for Index Fund Portfolios,” which was published in the January/February 2014 issue of the Journal of Indexes—used live data from both index and actively managed funds to perform 5,000 simulated trials by randomly selecting actively managed funds from each asset class.

The authors found that, as they increased the number of actively managed funds, the odds of the portfolio outperforming decreased. With a 10-fund portfolio, the odds of failure were 90%. And again, that was based on pretax results.

We’ll now turn to yet another explanation for why it’s so difficult to identify the future winners.

Returns Are Dominated By Very Few Stocks

Most investors are aware of the fact that small-cap stocks and value stocks historically have provided higher returns than large and growth stocks. But what many investors are probably unaware of is that those excess returns are the result of a very small number of stocks “migrating” out of their asset class. Said another way, a small-cap (value) stock performs so well that it becomes a large-cap (growth) stock.

For example, Peter Knez and Mark Ready—authors of the September 1997 study, “On the Robustness of Size and Book-to-Market in Cross-Sectional Regressions,” which was published in The Journal of Finance—found that the negative relationship between size and returns is driven by a very few extreme positive returns in each month.

In fact, when only 1% of each month’s observations are trimmed, there is a significant positive relationship between firm size and returns (large-caps now outperform small-caps).

‘Turtle Egg’ Effect

The authors called this the “turtle egg” effect: “Investors who own small-cap stocks anticipate a few major successes and many minor disappointments. That is, they lay many ‘turtle eggs,’ hoping a few will hatch and make it to the ocean.”

Here’s another example of how the performance of a small number of stocks can sometimes explain much of the returns to a certain asset class. From 1926 through 2009, equities, as measured by the Center for Research in Security Prices total market index, returned 9.6% per year.

If you exclude the top 10% of performers, the return falls by more than one-third, to 6.2%. If you exclude the top 25% of performers, the return becomes slightly negative (-0.6%). That means the top 25% of performers accounted for more than 100% of the returns.

Of course, if one could eliminate the bottom 10 or 25% of performers, then returns would increase just as dramatically. Unfortunately, the evidence demonstrates that after accounting for expenses, active managers have been persistently unable to generate alpha by prospectively identifying the star performers and avoiding the losers.

This finding provides a valuable insight for investors choosing between active and passive strategies. Thousands of small-cap stocks exist. No researcher, or active manager, could possibly follow all of them.

So investors must ask themselves: If the excess returns from small-cap stocks come from just 1% of companies, how likely is it that an active manager will be able to identify the few “turtle eggs” that will hatch and make it to the sea?

More Evidence

Here are two more examples of how much of excess returns are driven by very few stocks. First, of the 500 firms selected for the original S&P 500 Index in 1957, only 74 remained on the list in 1998, and only 12 outperformed the index over the entire period.

Second, in his own study, my former colleague, Vladimir Masek, found that of the 500 companies in the S&P 500 as of Oct. 1, 1990, only 302 (or 60.4%) were even still in existence 10 years later.

Of those 302 companies (which certainly includes survivorship bias, as many companies that didn’t survive in all likelihood produced poor returns) only 79 (or 26.2%) beat the Vanguard’s S&P 500 index fund.

Perhaps even more surprising is that 74 stocks (or 24.8%) returned less than riskless one-year Treasury bills. And 45 stocks (or 14.9%) managed to return less than inflation, as measured by the CPI. And perhaps most important from a risk management perspective, 32 stocks (or 10.6%) had negative returns. Stocks are risky, and diversification reduces risk.

The above examples demonstrate how difficult it is to find the proverbial needles in the haystack. The winning strategy is simply to own the haystack, and to own it all the time.


Heaton, Polson and Witte concluded: “To the extent that those allocating assets have assumed that the only cost of active investing above indexing is the cost of the active manager in fees, it may be time to revisit that assumption. The stakes for identifying the best active managers may be higher than previously thought.”

They add this: “The relative likelihood of underperformance by investors choosing active management likely is much more important than the loss to those same investors of the higher fees for active management relative to passive index investing. Thus, the stakes for finding the best active managers may be larger than previously assumed.”

To the extent you’re a risk-averse investor, which the vast majority of investors are, considering the risk-adjusted odds of outperforming is important when determining which strategy you should implement.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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