"Indexing refers to an investment methodology
that attempts to track a specific market index (either broadly or narrowly
focused) as closely as possible after accounting for all expenses incurred to
implement the strategy. As a result of this objective, investors should expect
an index fund to underperform its targeted benchmark by the amount of its
expenses. This objective differs substantially from that of traditional
investment managers, whose objective is to outperform their targeted benchmark
even after accounting for all expenses. Indeed, an oft-cited benefit of
actively managed investments is the opportunity for outperformance.
This paper explores the theory behind indexing as an
investment strategy and provides evidence to support its use in investor
portfolios. To do so, we examine the performance of a range of funds
available to U.S. investors. We first compare the records of actively
managed funds with those of various unmanaged benchmarks. We demonstrate
that, after costs: (1) the average actively managed fund has underperformed
various benchmarks; (2) reported performance statistics can deteriorate
markedly once “survivorship bias” is accounted for (that is, once the results
of funds that were removed from the public record are included); and (3)
persistence of performance among past winners is no more predictable than a
flip of a coin.
We then compare the performance of actively managed
funds with passive—or indexed—funds. We demonstrate that low-cost index funds
have displayed a greater probability of outperforming higher-cost actively
managed funds, even though index funds generally underperform their targeted
benchmarks. We conclude that indexing can be a viable strategy for U.S.
investors across a range of asset classes and markets."
