Thinking about Indices and “Passive” versus Active Management

Abstract

Trillions of dollars are indexed to various benchmarks, which the authors refer to as paper indices. Paper indices are based on a surprisingly large number of arbitrary, active decisions that are made by the organizations that sponsor them. Fuller, Han, and Tung investigate the importance of these active decisions on benchmark returns by constructing their own paper index, allowing them to estimate the amount of shortfall relative to their index that an indexer would incur due to transaction costs related to mimicking the index. The estimated shortfall is 2 to 4 basis points a year, depending upon the assumptions made regarding transaction costs. The authors also show that traditional indexing, relative to the benchmark they constructed, can be improved—using only market value data available to any indexer—by about 25 to 30 basis points a year after transaction costs. The authors conclude that no investment strategy is passive. Although the strategy of traditional indexing has a number of attractive attributes, it is not passive in the sense that the word passive is commonly used.