When Should Investors Choose an Alternative to Passively Investing in a Capitalization-Weighted Index?

Abstract

We present a framework for deciding when to choose an alternative to passively investing in capitalization-weighted indices within any particular asset class. Five reasons are identified for seeking an alternative. Three of these reflect situations where a capitalization-weighted index is either unavailable or unsuitable, while the other two relate to expectations that active management can outperform the index. We highlight the need to shift the debate over active versus passive investing towards a broader discussion that takes into account aspects such as differences across investors and the efficacy of the index itself. Our key message is that the best way to structure asset class portfolios is likely to depend on the circumstances.

Keywords: Investment management

JEL Classification: G11, G23