How Do Indexers Do Better Than Average?

by: Cullen Roche

One of the more common investing myths is the idea that indexing is necessarily "average."¹ It makes sense at first. If you bought all of the stocks in the market then you'd generate the average return. It would be like playing fantasy football and picking all of the players in the NFL. You would lose more often than not because there is no way you're going to beat the team that has Tom Brady, Adrian Peterson, Antonio Brown or, well, any of the above average players in the league. But the problem is that this isn't at all how investing works because there are frictions in investing that make these sorts of comparisons apples and oranges.

Using our fantasy football analogy -- imagine that the average team has 10 positions and the average player scores 10 points. If you own "the market team" then you score 100 points on average because you generate the average weekly points at each position. But the best teams in the league score 120 points on average because they are loaded with top performers. By being able to pick the best players you "beat the average." But the problem with investing is that we don't earn the average return of the best performing financial assets. We earn the after-tax and fee returns of these instruments. And this is where the idea of "average" gets muddled.

So, what happens to the fantasy football team with the best players when you add in frictions? Well, imagine that your league commissioner docked you 10 points for "fees" every week and docked you another 15 points for "taxes" as a result of your extra activity. Suddenly, your "above average" score drops to just 95! You're actually losing to the average. And this is precisely what happens to most highly active fund managers and traders. Because they're more active they tend to churn up more short-term capital gains. But they're also charging you 1% or so per year. So, if the average return on stocks is 10% per year and the average top tier manager earns 12% per year then they're beating the average before taxes and fees. But once you lop off their 1% fee and the extra 1.5% in taxes per year due to short-term capital gains they consistently underperform the market average as the annual performance data clearly confirms.

Of course, there will be outliers who can consistently beat even that high hurdle of 12% and they'll make up for their extra frictions, but finding those managers who can consistently achieve this is difficult, if not impossible. As a result, most indexers do better than the average active stock picker simply because they're engaging in a form of asset picking that is more efficient after taxes and fees. In other words, indexers are actually better than average because they don't incur the average fees and taxes most active investors do!

¹ - See, for instance, this WSJ piece titled "You Don't Have to Settle For Average Investing Returns".