What is indexing?

Indexing is a passive investment strategy that attempts to track the returns of a specific market index as closely as possible by holding all or a representative selection of securities in the index.

 

Indexing as a zero-sum game

The zero-sum game concept helps explain why indexing can be an attractive investment strategy. The theory states that the aggregate holdings of all investors in a particular market form that market. At any time, half of invested assets must outperform the average market return and the other half must underperform it. Once costs are subtracted, though, it becomes increasingly difficult to beat the average market return. This graphic helps tell the story.

 

A rationale for indexing

The efficient market hypothesis (EMH) was developed in part by U.S. economist Eugene Fama. The theory argues that it's impossible to beat the market through stock selection or market-timing because stock prices already reflect all relevant information. Therefore, buying and selling securities with the intention of outperforming the market is purely a game of chance.

Most investment professionals—including devoted indexers—do not fully subscribe to the theory of efficient markets. Instead, they believe that there are some inefficiencies in markets where value can be added, despite the many obvious advantages of indexing. However, it is important to note that the zero-sum game theory applies in all markets, even inefficient ones.