Why Indexing Works

7 Pages Posted: 14 Oct 2015 Last revised: 15 Mar 2018

J.B. Heaton

University of Chicago Law School

Nick Polson

University of Chicago - Booth School of Business

Jan Witte

University College London - Department of Mathematics

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, 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)

University of Chicago Law School ( email )

1111 East 60th Street
Room 608
Chicago, IL 60637
United States

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 Witte

University College London - Department of Mathematics ( email )

Gower Street
London, WC1E 6BT
United Kingdom

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