The Rise of the Index

Index investing by way of exchange traded funds (ETFs) and mutual funds has grown from a $500 million industry in the 1980s to a $4 trillion industry today. As of late, there has been a significant amount of conjecture about what this means for the future of investing and as a result we would like to share our own perspective on the topic. It is well known that the vast majority of active managers are unable to outperform their benchmark average. In fact, over a 10-year period, 98.9% of active U.S. equity funds failed to beat their benchmark. Provided with this evidence, any rational investor would choose an index fund. Some might say active management is dead and everyone should just invest in index funds. But by jumping to this conclusion immediately, many crucial factors are ignored. While low-cost, index investing can be a good option for the general public, there are other considerations to take into account.

If an investor wanted to re-create an investment in an index fund themselves, it would be expensive due to the transaction costs involved. Since an index is simply a large group of stocks, one cannot buy an index outright without a vehicle such as an ETF or mutual fund. ETFs and mutual funds recreate an index, such as the S&P 500, by purchasing the index constituents and rebalancing the securities to match their weighting in the index. Therefore, there is trading involved, just like an active manager, and transaction costs become an issue. Luckily index funds charge low fees, so while they will track an index, there is some drift due to fees. The important takeaway is that trading needs to take place within index funds. Many index funds have labeled themselves as “passive strategies,” but this is misleading. Since trading must take place to stay in-line with an index, it is no different than following an active strategy.

So, the question remains as to why the majority of active managers underperform their benchmark. While many factors can be blamed, the primary one is consistency. When someone invests in an index fund, they are subscribing to a simple, yet systematic and relentlessly consistent strategy. Active investment managers, even highly skilled ones, suffer from a lack of consistent implementation. It is extremely difficult for an individual manager to pick stocks based on qualitative factors, but to do so consistently year after year is nearly impossible. Herein lies the problem, humans are poor at being consistent. Despite this, the egos of those on Wall Street lead them to believe they have what it takes to outperform and they use this to persuade their clients of the same.

To reinforce this notion, it is helpful to examine an example outside the field of finance. A 2002 experiment by a group of legal scholars and political scientists was designed to predict the outcome of Supreme Court cases using a simple model. The model performed surprisingly well, accurately predicting 75% of the cases analyzed. Legal experts were only able to accurately predict 59% of cases. Here we see the benefits of a simple, yet consistent strategy outperforming experts in the field. Therefore, we find it unsurprising that the vast majority of active investment managers have a difficult time consistently outperforming their benchmarks over long periods of time. The primary means by which active managers can add value for their clients is by developing investment models that harness the most powerful feature of index funds; consistency.