One of the perks of my job is I get to speak at conferences and share Vanguard’s perspective. Because I represent Vanguard, I often find myself on a conference panel discussion alongside colleagues from predominantly active management firms, with the topic usually focused on the so-called “active versus passive” debate.

The assumption, of course, is that I will be solely a proponent of indexing. However, Vanguard manages $1 trillion of actively managed assets,1 so I end up being more balanced than some people expect (more on that later).

The moderator, panelists, and attendees are often surprised when I begin my remarks. I state that I am not there to cite statistics to show simply that indexing works. Rather, I am there to explain why indexing works—and they are even more surprised when I tell them that it’s not because of market efficiency.

I start by level-setting. The case for indexing is predicated on the zero-sum game, which states that, at any given time, the market consists of the cumulative holdings of all investors and that the aggregate market return is equal to the asset-weighted return of those investors. Since the market return represents the average return of all investors, for each position that outperforms the market, there must be a position(s) that underperforms the market by the same amount, such that, in the aggregate, the excess return of all invested assets equals zero (that is, excess return is “zero sum”).

Of course, this is before costs.

Every basis point of cost is a basis point of return that investors do not capture, and as costs, such as a fund’s expense ratio, rise, excess returns tend to fall. The figure below—which I don’t always get to bring with me for panel discussions—illustrates this relationship for small-capitalization blend mutual funds. You’ll notice that the red dots show that index funds are not immune from this higher expense ratio/lower excess return relationship.


At this point the moderator usually interjects a question. In fact, on one occasion, a moderator—thinking my rationale was inconsistent—asked, “But, Jim, by that logic, doesn’t that mean there are active managers that outperform?”

The moderator couldn’t have teed it up any better to help me make the point I always want to stress: I leaned forward into the microphone and simply replied, “Yes.”

After a brief pause, I explained that the case for indexing doesn’t mean that indexing beats all active, all the time. It means that indexing—and in particular low-cost indexing—gains an advantage because costs associated with it tend to be lower than the costs associated with active management, so by that notion low-cost indexing is designed to outperform the average active manager over longer periods of time.

Sometimes the case for low-cost index-fund investing might seem less or more compelling, including instances where investors might be better off with low-cost active choices. You can read about these considerations in The case for low-cost index-fund investing. Like me on the speaking circuit, I bet you’ll find the research a bit more balanced than you thought.

1 U.S.-domiciled assets as of December 31, 2015.


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