Douwe Osinga's Blog: If index followers win, who will lead?

Sunday, July 6, 2003

If index followers win, who will lead?

You can't beat the index when it comes to the stock market, that is, not everybody can, because then the index would be doing better, the index being the average. People investing in active management funds are therefore suckers, unless they somehow know which active funds are going to perform above average (and on average they don't). According to morningstar, an active fund manager takes 1.45% of the capital per year. And most people in active funds, try to beat the market by getting into the best active funds, which means switching, which costs even more money. On average, tracking the index is the best for the individual investor.

Right now, most people don't seem to realize. 90% of the mutual fund money goes into actively managed funds, only 10% follows the index. But what if people would come to their senses? What if all people would put their money in index-trackers? Who would then lead the indexes, i.e. how would the index know where to go to?

For that matter, how does it work now? In a perfect market, all available information is already incorporated in the market and the index always knows best. But before the information goes into the market, somebody has the opportunity to profit. Insider trading, you can call this. It happens when somebody knows something, before the market does, but it also happens when some people just have faster access to trading platforms when news breaks.

The lesson: follow the index at all times, unless you have insider information. But if that holds, in the long run only the people with insider information will trade actively, making it very easy to bust them.