The indexing revolution: Why indexing works

Gus Sauter: Since outperformance is a zero-sum game before costs, it's a negative-sum game after costs. So it turns out that marginal outperformers before costs become underperformers after costs. And so a majority of active investors should underperform the market itself.

John Rekenthaler: When I started in the business 20 years ago, the assumption was the professional managers who actively ran mutual fund portfolios would be in the winning side of the trades and that the individual investors would be on the losing side of the trades. So that's how it was explained that you could have a zero-sum or negative-sum game as you explained; yet managers could always win. But as we see with the evidence, that's not the way it played out.

Gus Sauter: What we do observe is that really in all segments of the market, if we look at the nine Morningstar style boxes, and you can see large-cap growth for instance, 79% of all active managers with a large-cap growth style have underperformed a large-cap growth index. And by, on average, 1.1%. This is over the last 15 years, 15-year time horizon, and you can see in the nine different style boxes, only in one style box have active managers actually beaten their index, and it's only by .02%, and in fact, actually 63% of them underperform the index.

Jane Bryant Quinn: And if I can add something to that, people who say well I'm not going to be an indexer 'cause I'm going to find that manager that outperforms, you say, oh well, look, 30% are outperforming the index. The only problem is that it's a different 30% every time you run the timeline. So you say, okay, my guy has outperformed the index for five years, but then the next five years, some other guy is going to outperform the index and you're under, and you say hey, wait a minute. What about these people that outperform the index all the time? Friends, there aren't any. They don't outperform the index all the time. I did one using Morningstar data once upon a time, some years ago we did, I did for my column a rolling study of who was outperforming over five years and over 10 years using a rolling monthly average. And I looked at it, and here were all these different funds all the time. There was not one single fund at that time that had outperformed its benchmark over 15 years.

There are these guys are outperforming only part of the time, and the rest of the time you're down in what you call a zero-sum game, and which I call a loss.

Gus Sauter: Recognize even the best managers—the ones that had the best success over time—they win on maybe 52-53% of their stock picks. They lose on 47-48% of their stock picks. So it's a razor-thin margin. It's not easy picking stocks. Even the best in the world, they just barely turn the odds in their favor.

Disclosures

• All investments are subject to risk. Past performance is no guarantee of future results. The information provided here is for educational purposes only and isn’t intended to be construed as investment advice.
• Past performance is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
• Opinions expressed by our guests do not necessarily reflect those of Vanguard or its management.
• For the table labeled “The performance challenge,” equity benchmarks are represented by the following indexes: Large Blend: S&P 500: 1/1995-11/2002, MSCI Prime Market 750: 12/2002-current; Large Value: S&P 500 Value: 1/1995–11/2002, MSCI Prime Market 750 Value: 12/2002–current; Large Growth: S&P 500 Growth 1/1995–11/2002, MSCI Prime Market 750 Growth 12/2002–current; Mid Blend: S&P Midcap 400: 1/1995–11/2002, MSCI Mid Cap 450: 12/2002–current; Mid Value: S&P Midcap 400 Value: 1/1995–11/2002, MSCI Mid Cap 450 Value: 12/2002–current; Mid Growth: S&P Midcap 400 Growth: 1/1995–11/2002, MSCI Mid Cap 450 Growth: 12/2002–current; Small Blend: S&P Small Cap 600: 1/1995–11/2002, MSCI Mid Cap 1750: 12/2002–current; Small Value: S&P Smallcap 600 Value: 1/1995–11/2002, MSCI Small Cap 1750 Value: 12/2002–current; Small Growth: S&P Small cap 600 Growth: 1/1995- 11/2002, MSCI Small Cap 1750 Growth: 12/2002–current.