Index funds, which hardly existed 50 years ago, now play a prominent role in global financial markets. Exhibit 1 illustrates the growth of assets tracking the S&P 500®, the most prominent index in the world’s largest equity market, but this trend has not been limited to the U.S. (nor to equities).
The growth of indexing has been driven by the inability of active managers, in aggregate, to outperform passive benchmarks. This is not a new development—it was first reported 90 years ago. The rise of passive management is the consequence of active performance shortfalls.
These shortfalls can be attributed to three factors:
- The professionalization of investment management;
- Cost; and
- The skewness of stock returns.
Since each of these factors is likely to persist, the advantage of indexing over active management is likely to persist as well.
Some Important Observations
Until the early 1970s, there were no index funds; all assets were managed actively. The subsequent shift of assets from active to passive management, as illustrated in Exhibit 1, surely must count as one of the most important developments in modern financial history. Our intent in this paper is to suggest why this transformation came about; the answer, in our view, lies both in a set of observations and in the subsequent explanation of those observations.
The observations to which we refer are designed to document the degree to which active managers are able to add value to the performance of passive benchmarks. The earliest study of active management of which we’re aware dates to 1932. Alfred Cowles examined the stock selection records of both financial services and fire insurance companies (what we would today call property and casualty insurers). Both sets of forecasters underperformed the average common stock during the period Cowles examined. The same was true of a number of financial publications that made predictions of the overall level of the stock market. For all these cases, “statistical tests…failed to demonstrate that they exhibited skill, and indicated that they more probably were [the] results of chance.”