Why Indexing Works

TL;DR

This paper presents a simple stock selection model explaining why active managers often underperform benchmarks, emphasizing the difficulty of outperforming indices due to the distribution of stock performances.

Contribution

It introduces a model that explains underperformance of active management based on empirical observations of stock performance within indices.

Findings

Random stock selection can lead to underperformance

Active management faces significant challenges in outperforming indices

The likelihood of underperformance is higher than previously thought

Abstract

We develop a simple stock selection model to explain why active equity managers tend to underperform a benchmark index. We motivate our model with the empirical observation that the best performing stocks in a broad market index often perform much better than the other stocks in the index. Randomly selecting a subset of securities from the index may dramatically increase the chance of underperforming the index. The relative likelihood of underperformance by investors choosing active management likely is much more important than the loss to those same investors from the higher fees for active management relative to passive index investing. Thus, active management may be even more challenging than previously believed, and the stakes for finding the best active managers may be larger than previously assumed.