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.

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