The Case for Index Fund Investing

April 30, 2013

The Vanguard Group

Indexing refers to an investment methodology that attempts to track a specific market index (either broadly or narrowly focused) as closely as possible after accounting for all expenses incurred to implement the strategy. As a result of this objective, investors should expect an index fund to underperform its targeted benchmark by the amount of its expenses. This objective differs substantially from that of traditional investment managers, whose objective is to outperform their targeted benchmark even after accounting for all expenses. Indeed, an oft-cited benefit of actively managed investments is the opportunity for outperformance.

This paper explores the theory behind indexing as an investment strategy and provides evidence to support its use in investor portfolios. To do so, we examine the performance of a range of funds available to U.S. investors. We first compare the records of actively managed funds with those of various unmanaged benchmarks. We demonstrate that,after costs: (1) the average actively managed fund has underperformed various benchmarks; (2) reported performance statistics can deteriorate markedly once “survivorship bias” is accounted for (that is, once the results of funds that were removed from the public record are included); and (3) persistence of performance among past winners is no more predictable than a flip of a coin. We then compare the performance of actively managed funds with passive— or indexed—funds. We demonstrate that low-cost index funds have displayed a greater probability of outperforming higher-cost actively managed funds, even though index funds generally underperform their targeted benchmarks. We conclude that indexing can be a viable strategy for U.S. investors across a range of asset classes and markets.

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