Vanguard: Debunking Myths About Indexing

Vanguard: Debunking Myths About Indexing

Small excerpt from Vanguard. Myth #1 has always bothered me so much, I am glad Vanguard addresses it; This is so important for investors to realize. Anyway, excerpt followed by full article.

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The effectiveness of indexing as an investment strategy has clearly taken hold in the industry, as evidenced by the difference in cash flows between active and passive strategies (both equity and fixed income) over the past six years.

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The first London Value Investor Conference was held in April 2012 and it has since grown to become the largest gathering of Value Investors in Europe, bringing together some of the best investors every year. At this year’s conference, held on May 19th, Simon Brewer, the former CIO of Morgan Stanley and Senior Adviser to Read More

The success of indexing is grounded in the theory of the zero-sum game, an economic and mathematical truism that starts with the understanding that at every moment, the holdings of all investors in a particular market aggregate to form that market (Sharpe, 1991).

Yet despite the theory and publicized long-term success of indexed investment strategies, criticisms and misconceptions remain.

Myth #1: Indexing only works in ‘efficient’ markets

One of the most persistent myths in the investment industry is that it makes sense to use an index strategy in efficient markets, for instance with large-capitalization stocks, but to use an active strategy in inefficient segments. It’s important to note that the term inefficient is often used to refer to informational inefficiencies. But investors must also consider the full spectrum of costs in those markets deemed less efficient.2 The fallacy of the “efficient-market” myth is that the underlying objective of indexing is to own the market (whatever that market may be) and to get the return of that market (minus costs). The indexing concept makes no judgment as to market efficiency, size, or style, nor does it need efficient markets to be effective: Every market will always have an average return, whether the market is deemed efficient or otherwise.

Indexing works because of the cost-matters hypothesis (Bogle, 2005), which states that “whether markets are efficient or inefficient, investors as a group must fall short of the market return by the amount of the costs they incur” see (Figure 1 on page 2). Well-managed index funds strive to minimize all the costs of investing in a particular market. Figure 2 (on page 2), specifically the lackluster results of active management for smallcap blend equities and emerging-market equities, demonstrates the advantages of a passive strategy in two markets often considered inefficient.

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