Randomly selected stocks underperform the overall market more often than they outperform, according to researchers, due to their theoretically unlimited upside and finite downside.
Furthermore, this likelihood of underperformance is even more costly to investors than the fees incurred from hiring an active manager, wrote attorney and scholar JB Heaton, statistician Nick Polson (University of Chicago), and quant Jan Hendrik Witte (University of Oxford)
“Our results suggest that that the much higher cost of active management may be the inherently high chance of underperformance that comes with attempts to select stocks,” they wrote in “Why Indexing Works,” published earlier this month. “To the extent that those allocating assets have assumed that the only cost of active indexing above indexing is the cost of the active manager in fees, it may be time to revisit that assumption.”
For the study, the authors constructed a simple model with five securities, in which active managers picked one or two stocks and weighted them equally. Four of the stocks returned 10% over the period, while one returned 50%—meaning only those managers skilled (or lucky) enough to select the winning security were able to beat the index.
The result was that the risk of substantial index underperformance always dominated the chance of substantial index outperformance, with the difference being greater the fewer stocks a portfolio included relative to the index.
“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,” they wrote.
As the authors conclude, the “stakes for identifying the best active managers may be higher than previously thought.”