Small Number of Stocks Drive Indexes

Here’s an interesting collection of recent research that helps explain why index investing often beats active stock selection. The bottom line is that in most years only a small number of stocks drive the indexes higher. Active managers are more likely not to own those stocks than indexes are. I’d add that value managers are less likely to own the few stocks, because these likely have become momentum stocks trading at high valuations. An interesting point in the article is that the percentage of active managers outperforming indexes declined over the last decade.

In their stock selection model, the authors randomly select a small subset of securities from an index and found that doing so maximizes the chance of outperforming the index—the allure of active equity management—but it also maximizes the chance of underperforming the index, with the chance of underperformance being larger than the chance of outperformance.

They also found that “the risk of substantial index underperformance always dominates the chance of substantial index outperformance, with the difference being greater the smaller the size of the selected sub-portfolios.”

The authors write: “It is far more likely that a randomly selected subset of the 500 stocks will underperform than overperform, because average index performance depends on the inclusion of the extreme winners that often are missed in sub-portfolios.”