Why Indexing Works

7 Pages Posted: 14 Oct 2015 Last revised: 12 May 2017

J.B. Heaton

Bartlit Beck Herman Palenchar & Scott LLP

Nick Polson

University of Chicago - Booth School of Business

Jan Hendrik Witte

University of Oxford - Mathematical Institute

Date Written: May 10, 2017

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.

Keywords: Indexing, Passive Management, Active Management

JEL Classification: G10, G11

Suggested Citation

Heaton, J.B. and Polson, Nick and Witte, Jan Hendrik, Why Indexing Works (May 10, 2017). Available at SSRN: https://ssrn.com/abstract=2673262 or http://dx.doi.org/10.2139/ssrn.2673262

J.B. Heaton (Contact Author)

Bartlit Beck Herman Palenchar & Scott LLP ( email )

Courthouse Place
54 West Hubbard Street
Chicago, IL 60610
United States
312-494-4425 (Phone)
312-494-4440 (Fax)

Nick Polson

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-7513 (Phone)
773-702-0458 (Fax)

Jan Hendrik Witte

University of Oxford - Mathematical Institute ( email )

United Kingdom

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