The case for low-cost index-fund investing by Dr. Jan-Carl Plagge and James J. Rowley Jr., CFA

The case for low-cost index-fund investing by Dr. Jan-Carl Plagge and James J. Rowley Jr., CFA

Index investing was first made broadly available 
to US investors with the launch of the first indexed 
mutual fund in 1976. Since then, low-cost index 
investing has proven to be a successful investment 
strategy over the long term, outperforming the 
majority of active managers across markets and 
asset styles (S&P Dow Jones Indices, 2015). In part 
because of this long-term outperformance, index 
investing has seen exponential growth among 
investors, particularly in the United States, and 
especially since the global financial crisis of 2007–
2009. In recent years, governmental regulatory 
changes, the introduction of indexed ETFs and a 
growing awareness of the benefits of low-cost 
investing in multiple world markets have made index 
investing a global trend. This paper reviews the 
conceptual and theoretical underpinnings of index 
investing’s ascendancy (along with supporting 
quantitative data) and discusses why we expect 
index investing to continue to be successful and to 
increase in popularity in the foreseeable future.
A market-capitalisation-weighted indexed 
investment strategy – via a mutual fund or an 
ETF, for example – seeks to track the returns of a 

market or market segment with minimal expected 
deviations (and, by extension, no positive excess 
return) before costs, by assembling a portfolio 
that invests in the securities, or a sampling of the 
securities, that comprise the market. In contrast, 
actively managed funds seek to achieve a return or 
risk level that differs from that of a market-cap-

weighted benchmark. Any strategy, in fact, that 
aims to differentiate itself from a market-cap-

weighted benchmark (e.g., “alternative indexing”, 
“smart beta” or “factor strategies”) is, in our view, 
active management and should be evaluated based 
on the success of the differentiation.
This paper presents the case for low-cost index-

fund investing by reviewing the main drivers of its 
efficacy. These include the zero-sum game theory, 
the effect of costs and the difficulty of finding 
persistent outperformance among active managers. 
In addition, we review circumstances under which 
this case may appear less or more compelling than 
theory would suggest, and we provide suggestions 
for selecting an active manager for investors who 
still prefer active management or for whom no 
viable low-cost indexed option is available.

Notes on risk and performance data:
Investments are subject to market risk, including the possible loss of the money you invest. Bond funds 
are subject to the risk that an issuer will fail to make payments on time, and that bond prices will 
decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. 
Diversification does not ensure a profit or protect against a loss in a declining market. Performance 
data shown represent past performance, which is not a guarantee of future results. Note that 
hypothetical illustrations are not exact representations of any particular investment, as you cannot 
invest directly in an index or fund-group average.

Zero-sum game theory 
The central concept underlying the case for index-

fund investing is that of the zero-sum game. 
This theory states that, at any given time, the 
market consists of the cumulative holdings of all 
investors, and that the aggregate market return 
is equal to the asset-weighted return of all market 
participants. Since the market return represents 
the average return of all investors, for each position 
that outperforms the market, there must be a 
position that underperforms the market by the 
same amount, such that, in aggregate, the excess 
return of all invested assets equals zero. Note 
that this concept does not depend on any degree 
of market efficiency; the zero-sum game applies to 
markets thought to be less efficient (such as small-

cap and emerging market equities) as readily as 
to those widely regarded as efficient (Waring and 
Siegel, 2005).
Figure 1 illustrates the concept of the zero-sum 
game. The returns of the holdings in a market form 
a bell curve, with a distribution of returns around 
the mean, which is the market return. 
It may seem counterintuitive that the zero-sum 
game would apply in inefficient markets, because, 
by definition, an inefficient market will have more 
price and informational inefficiencies and, therefore, 
more opportunities for outperformance. Although 
this may be true to a certain extent, it is important 
to remember that for every profitable trade an 
investor makes, (an)other investor(s) must take the 
opposite side of that trade and incur an equal loss. 
This holds true regardless of whether the security 
in question is mispriced or not. For the same 
reason, the zero-sum game must apply regardless 
of market direction, including bear markets, where 
active management is often thought to have 
an advantage. In a bear market, if a manager is 
selling out of an investment to position the portfolio 
more defensively, another or others must take the 
other side of that trade, and the zero-sum game 
still applies. The same logic applies in any other 
market, as well.

Some investors may still find active management 
appealing, as it seemingly would provide an even-odds 
chance of successfully outperforming. As we discuss 
in the next section, though, the costs of investing make 
outperforming the market significantly more difficult 
than the gross-return distribution would imply.
Effect of costs 
The zero-sum game discussed here describes a 
theoretical cost-free market. In reality, however, 
investors are subject to costs to participate in the 
market. These costs include management fees, 
bid-ask spreads, administrative costs, commissions, 
market impact and, where applicable, taxes – all of 
which can be significant and reduce investors’ net 
returns over time. The aggregate result of these 
costs shifts the return distribution to the left.

The case for low-cost index-fund investing by Dr. Jan-Carl Plagge and James J. Rowley Jr., CFA