Why Indexing Works

Heaton J.B., Polson N.G., Witte J.H.. Why indexing works. Appl Stochastic Models Bus Ind. 2017;33:690–693. https://doi.org/10.1002/asmb.2271


More and more research suggests that the underperformance of active equity managers is related to skewness in returns that makes it hard to beat an index. J.B. Heaton and Jan Hendrik Witte, along with our co-author Nick Polson, developed a simple stock selection model to study this phenomenon. Our model  is motivated by 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 (a model of worst-case active management) 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 those same investors take due to the higher fees of 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.

Subsequent work by Henrik Bessembinder of Arizona State University finds:

The majority of common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills. These results highlight the important role of positive skewness in the distribution of individual stock returns, attributable both to skewness in monthly returns and to the effects of compounding. The results help to explain why poorly-diversified active strategies most often underperform market averages.

Much of our work at Conjecture builds from these basic insights. A useful Bloomberg Markets piece on our work is available here.