January 4, 2016

Why Index Investing Wins - excellent article

Just A Few Winners Needed
Heaton, Polson and Witte, whose paper was published in October 2015, develop a simple model that builds on the underemphasized empirical fact that the best-performing stocks in a broad index perform much better than the other stocks in that index. In other words, average index returns depend heavily on the relatively small set of winners.

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.

Underperformance More Likely
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.”

Returns Are Dominated By Very Few Stocks
Most investors are aware of the fact that small-cap stocks and value stocks historically have provided higher returns than large and growth stocks. But what many investors are probably unaware of is that those excess returns are the result of a very small number of stocks “migrating” out of their asset class. Said another way, a small-cap (value) stock performs so well that it becomes a large-cap (growth) stock.

‘Turtle Egg’ Effect
The authors called this the “turtle egg” effect: “Investors who own small-cap stocks anticipate a few major successes and many minor disappointments. That is, they lay many ‘turtle eggs,’ hoping a few will hatch and make it to the ocean.”

This finding provides a valuable insight for investors choosing between active and passive strategies. Thousands of small-cap stocks exist. No researcher, or active manager, could possibly follow all of them.

So investors must ask themselves: If the excess returns from small-cap stocks come from just 1% of companies, how likely is it that an active manager will be able to identify the few “turtle eggs” that will hatch and make it to the sea?

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