Why Would Anybody Buy Everything? Because Picking Winners Is Hard

An index is a defined list of companies with a rule for how much weight each carries, typically according to size. A fund tracking it holds those companies in those proportions and does nothing else, buying and selling only when the index composition changes. There is no analysis, no forecasting and no judgement about which companies will do well, which is the point rather than a limitation. Because the work involved is minimal, the fees charged are a small fraction of those charged by funds employing analysts, and because the fund holds everything, its return before fees is by construction the average return of the market it tracks.

The central argument is simpler than it sounds:

• •All investors together hold the whole market, so their average return is the market return
• •That is true before costs, as a matter of arithmetic rather than of evidence
• •Every investor pays costs, which come out of that return
• •So the average investor must underperform the market by the average cost
• •Active funds cost far more to run than tracking funds
• •Therefore the average active investor must underperform a tracker

The arithmetic is about averages and the evidence concerns whether any particular manager can beat it consistently. Long-running studies comparing active funds against their benchmarks find that a majority underperform over any period beyond a few years, and that the proportion failing rises the longer the period examined, reaching very high figures over fifteen or twenty years. Funds that outperform in one period show little tendency to do so in the next, which is the finding that matters, since persistent skill would show up as persistence in the results. Some managers do beat the market over long periods, and distinguishing them in advance from the number who would do so by chance has proved extremely difficult.

The approach was proposed academically long before anybody could buy one, and the sequence is worth knowing. Research through the 1960s established that professional managers as a group did not beat the market after costs, which was unwelcome and was published anyway. The first fund open to the public was launched by John Bogle in 1976 and attracted derision, being described in the industry as un-American and as a guarantee of mediocrity, and it raised a small fraction of what was intended. Assets grew slowly for a decade and then enormously, and funds tracking indices now hold a substantial share of all invested money worldwide, with the share crossing half of American equity fund assets in recent years.

Several criticisms of the approach are substantive rather than defensive. If everybody tracked an index, nobody would be analysing companies and prices would stop reflecting information, so the strategy depends on enough other people doing the work, which raises a question about how far it can grow. Weighting by size means buying more of whatever has already risen, which concentrates holdings in a small number of very large companies and has done so increasingly. A small number of asset managers now hold substantial voting stakes in most large companies, which is a governance question nobody designed. And a tracker falls exactly as far as its market in a crash, which people underestimate until it happens.

Holding every company in an index in proportion requires no analysis, costs very little and returns the market average before fees. Since all investors together are the market, the average investor must trail it by the average cost, which is arithmetic rather than evidence. Most active funds underperform over long periods and past outperformance does not persist. The strategy depends on enough others still doing the analysis.