Passive funds tracking an index lose out when its make-up changes

IS THERE hope for fund managers after all? Conventional “active” managers, who try to pick stocks that will beat the market, have been losing ground to “passive” funds, which simply own all assets in a given sector in proportion to their market value. The main advantage of the latter group is that they charge a lot less.

William Sharpe, a Nobel prizewinning economist, argued in 1991 that the “arithmetic of active management” means that the average fund manager is doomed to underperform. To understand why, assume that there are equal numbers of active and passive managers and, between them, they own all the market. The market returns 10%. How much will the passive managers earn? The answer must be 10%, before costs. The active managers own that bit of the market the passive managers don’t. But that proportion of the market must, thanks to simple arithmetic, also return 10%, before costs. Since the costs of active investors are higher, the average active manager must underperform. These numbers...



via The Economist: Finance and economics Business Feeds

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