Why Indexing Works


Excited to be joining Alpha Theory’s Lunch and Learn Webinar focused on our research described below (written while J.B. Heaton was still toiling away in law!).

We develop a simple stock selection model to explain why active equity man-agers tend to underperform a benchmark index. We motivate our model with theempirical observation that the best performing stocks in a broad market indexoften perform much better than the other stocks in the index. Randomly select-ing a subset of securities from the index may dramatically increase the chanceof underperforming the index. The relative likelihood of underperformance byinvestors choosing active management likely is much more important than theloss those same investors take due to the higher fees of active management rel-ative to passive index investing. Thus, active management may be even morechallenging than previously believed, and the stakes for finding the best activemanagers may be larger than previously assumed.


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