The Power of Indexing

Only foolhardy investors aim to beat the market.

Index funds that attempt to capture the market’s overall returns—rather than trying to beat the market—regularly outperform their actively-managed competitors. Yet, that long-term evidence doesn’t seem to dissuade the proponents of active investment mangement: those that attempt to beat the market through stock selection, industry allocation or market timing.

Some investors have partially conceded the argument. They state that investors should use index funds for their portfolio’s core, the part invested in large stocks. At the same time, they argue that investors should use active management for the supposed “inefficient” areas of the market, such as the small-stocks and emerging-market asset classes. Proponents have dubbed this the “core and satellite” investment approach.

After doing an extensive study of this strategy, The Vanguard Group found, “Indexing is a powerful strategy in all segments of the market.” Vanguard looked at mutual-fund managers operating emerging-market and small-cap-stock funds from 1995 through 2009. Only one third of the emerging-market funds survived the entire period and beat their benchmark. Findings for active small-stock funds were similar.

Vanguard said, “We conclude that … the 95% of investors with less than perfect skill would have benefited from having a majority of their portfolios in a market index.”

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