Index Investing was introduced to investors with the launch of the first index mutual fund in 1976. Regulatory changes, the introduction of indexed Exchange Traded Funds (ETFs) and broad-base awareness of low-cost investing have contributed to the global growth of index investing, especially since the global financial crisis in 2007/8.

The conventional market-capitalisation-weighted indexed investment strategy, via a mutual fund or an ETF, seeks to track the returns of a market or market segment with minimal expected deviations, and by implication no positive excess returns, before costs. Returns are sought by assembling a portfolio that invests in the securities or a sampling of the securities that compose the market. Actively managed funds on the other hand seek to deliver positive excess returns by achieving a risk level and a correlating return that differs from that of a market-capitalisation-weighted benchmark, reference Figure 1, which is an illustration of the returns of a market comprised of various asset classes, where the mean is the market’s return and where the returns of holdings of the different asset classes of varying risk profiles are distributed around the mean.

The market return thus represents the average return for all investors and implies a zero-sum game i.e. for each position that outperforms the market there must be a position that underperforms the market by the same amount, such that the excess return at an aggregate level equates to zero. This concept holds true for efficient and inefficient markets, and for bear and bull markets.

The costs associated with active investing do however make it significantly more difficult for active managers to consistently outperform passive managers, despite the appeal of the even-odds suggested by the zero-sum game characteristic of the market. These costs include management fees, bid-ask spreads [1], administrative costs, commissions, market impact and, where applicable, taxes. The aggregate impact of these costs is a shift of returns to the left of the market return curve, reference Figure 2, which shows an investment with low costs (red line) versus an investment with high costs (blue line). Whilst the associated costs of both investments move the return curve to the left, the investment with higher costs moves the return curve more to the left than the one with lower costs. The implication, aggregate performance is less than the even-odds suggested by the zero-sum characteristic of the market, where investments that have higher costs require higher returns to deliver similar returns to those with lower costs.

As such, once costs are taken into consideration, active managers, who generally have higher costs than passive managers, have a higher probability to underperform. Market data supports this insight i.e. “negative excess returns tend to be more common than positive excess returns.”

Investors can reduce the risk associated with active investing i.e. a higher probability to underperform relative to their selected benchmark, if they seek the lowest possible cost for a given strategy. In most markets index funds have a significant cost advantage over actively managed funds. In addition, for those investors who are bullish on pursuing actively managed strategies it is worth noting that most active managers do not consistently maintain high performance, where such outperformance is recorded. Persistence is actually stronger amongst underperforming managers, across all asset classes. Time also has a significant impact on the applicability of relative zero-sum outperformance attributable to the effects of luck and market cyclicality i.e. in any given year the zero-sum characteristic of the market implies that some population of funds will outperform the market. As the time period is extended, however, the effects of luck and market cyclicality tend to cancel out, reducing the number of funds that outperform. Market cyclicality is an important factor in the lack of persistent outperformance as investment styles and market sectors go in and out of favour. By contrast, over a longer duration a low cost indexed strategy has a significant performance advantage, primarily because its cost advantage compounds over time.

Index funds seek to provide exposure to a market or a segment of a market through varying degrees of index replication. Irrespective of the replication method, all index funds seek to track the target market as closely as possible and do so without needing a similar level of resources as is required by active managers e.g. research, higher trading costs, etc. Low cost indexed investing is therefore a simple way (less complicated) for investors to gain market exposure whilst protecting against the risk associated with overexposure to a single asset, and is evidently the best opportunity at maximising returns over the long-term. In short, individuals and institutions alike have gained the ability to participate in the fortunes of a market in a single transaction.

Technology and data have transformed the range of investments that can be tracked by an index, facilitating choice that extends beyond traditional equity indexes i.e. stocks in proportion to their market-capitalisation, to a whole array of more dynamic indexes compiled according to other methodologies.

Vanguard, 2019 - 'The case for low-cost index fund investing.'

A bid-ask spread is the difference between the highest price that a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. The spread is the transaction cost.

Vanguard refers to Index Investing as passive, broadly diversified, market-capitalisation-weighted strategy, and considers any strategy that is not market-cap-weighted to be an active strategy.