Empirical Insights on Indexing

Winston-Salem (NC 27109). assive index funds that buy and hold the stocks in high-capitalization major market indexes like the Standard & Poor’s 500 stock index P have beaten the vast majority of actively run stock funds over the past few years. A glaring exception has been low-capitalization stock index funds. Passive index funds whose purpose is to match the performance of a small-stock benchmark, like the Russell 2000 index, have seen results that lag their actively managed small-stock fund peers. While Damato [1997] states that “overall, indexing has been a great mutual-fund investment strategy,” she quotes Vanguard Group president John J. Brennan as saying that Vanguard’s $1.6 billion passive small-stock fund is “the one anomaly among Vanguard’s numerous index funds, where the performance hasn’t been nearly as good against the actively managed small-stock fund.” A cost-efficient approach to indexing involves purchasing a selected sample of securities in an index. Rudd [1980] describes an optimization technique for forming passive indexed portfolios using a sample of stocks. The aim of the technique is to minimize the residual risk of the indexed portfolio compared to the index that it is designed to match. Using the S&P 500 as the index, Rudd compares the tracking results of the optimization approach to a less sophisticated stratification or cell approach in forming an indexed portfolio. His results show a 50% improvement in trachng error risk of the optimized indexed portfolio over the stratified indexed portfolio.