Why is it so hard to beat an index?

Written by John Osbon on July 24, 2012

Both practical experience and academic research show that active managers, on average, fight a losing battle when trying to beat indexes in their respective asset classes. Even managers who beat their benchmark for a year or two are not likely to continue for extended periods.

Active managers come to the battle well armed – able to exploit limitless research, fundamental and technical analysis, economic forecasts and so on. Hedge fund managers have even more tools – the use of derivatives, short selling, etc. But still most come up short. So what’s going on? WHY is it so hard to beat an index?

Let’s start with costs

Active investment management costs money.  There are analysts to be paid, big-salary portfolio managers, trading costs, not to mention marketing budgets aimed at outselling the competition.  By contrast, a so-called “passive” index approach bears almost none of those expenses since index ETFs are by definition rules-based, infrequently change in composition, and just don’t cost very much to operate.

Indexing is like using the internet to instead of the labor-intensive US mail to send hundreds of messages. It’s effective, far more efficient and costs almost nothing.

An advantage from the get-go

How much less does it cost to operate an index ETF?  As a recent Vanguard study shows, about 60 basis points (0.60%) annually for an equity fund and 35 basis points annually for fixed income. Those percentages may look small but compound quickly over time.  For hedge funds, the cost burden is even higher, often hundreds of basis points, because of so-called performance fees.

An active manager is behind from day one in performance due to higher costs. And remember, the costs recur year after year.  An active manager looks like an Olympic marathon runner starting hundreds of yards back from the starting line, and then being yanked hundreds of yards backward at every mile marker.

Not all “average” performance is created equal

Graphically this disadvantage looks like this, courtesy of Vanguard:

Because investing is a zero sum game, every dollar of outperformance (better than average) must be contributed by someone else’s dollar of underperformance (worse than average).  With its cost disadvantage, all active management performance shifts to the left – the dark blue curve. Therefore, the average active manager underperforms the average for the whole market.

It’s like the marathon runner who starts far behind the starting line. She finishes behind more than half of the field even if she runs the average pace of her competitors.

As Vanguard states: “To successfully play the zero-sum game, investors must find the minority of active investments that can consistently beat the market, despite their higher costs.” [See the Vanguard study showing how few active managers beat their index benchmarks.]

Furthermore

There’s another reason active management lags behind indexes: It’s difficult to predict the future. A few managers are able to do so over short timeframes, but predicting who they will be, before the fact, is just as hard as guessing what the market will do tomorrow.

Stop racing, start reaping

The investment management industry does us all a disservice by emphasizing “beating the index” as an investment goal. At Osbon Capital we are focused not on beating indexes, but on combining index-based investments in a wide range of asset classes to build diverse, risk-balanced portfolios and achieve client goals.

I feel that active management – beyond its cost disadvantage that causes it to lag behind average market returns – typically introduces needless risk and tax exposure and reduces diversification. We take the opposite approach, focusing on diversification, risk management, cash flow, cost control, and tax efficiency. We don’t race; we reap.

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