Abstract

https://ssrn.com/abstract=2673262
 


 



Why Indexing Works


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

November 24, 2016


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 perform much better than the other stocks in the index. While randomly selecting a subset of securities from the index increases the chance of outperforming the index, it also increases the chance of underperforming the index, with the frequency of underperformance being larger than the frequency of overperformance. The relative likelihood of underperformance by investors choosing active management likely is much more important than the loss to those same investors of the higher fees for active management relative to passive index investing. Thus, the stakes for finding the best active managers may be larger than previously assumed.

Number of Pages in PDF File: 5

Keywords: Indexing, Passive Management, Active Management

JEL Classification: G10, G11


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Date posted: October 14, 2015 ; Last revised: November 26, 2016

Suggested Citation

Heaton, J.B. and Polson, Nick and Witte, Jan Hendrik, Why Indexing Works (November 24, 2016). Available at SSRN: https://ssrn.com/abstract=2673262 or http://dx.doi.org/10.2139/ssrn.2673262

Contact Information

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)

Chicago Booth School of Business Logo

Jan Hendrik Witte
University of Oxford - Mathematical Institute ( email )
United Kingdom
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