Passives Produce Premium Performance

Hendrik Bessembinder has recently published here a study of individual, stock returns in the US with some startling new insights into the risks of equity investment. The study encompasses 90 years of monthly return data on every stock in the CRSP database – just about as large a database (25,782 distinct identifiers) as it is possible to compile in US equities, and so any results are likely to have greater statistical significance than most other studies of stock returns which typically use much shorter time periods.

Some of his key insights are:

·       58% of stocks underperform the returns from 1-month T-Bills over their entire lifetime

·       All of the dollar wealth created by the stock market since 1926 (nearly $32 trillion) is attributable to just the best-performing 4% of the stocks and 75% of that wealth to just the best-performing 1% of the stocks.

·       Of all the individual monthly stock returns in the entire database, just 48% beat T-Bill returns, and less than 50% are positive.

·       The median life of a stock on the database is 7 years. The median lifetime return of a stock is -3.67%.

·       Mean returns of stocks are much higher than median returns – stocks display significant positive skew.

·       Smaller capitalisation stocks are more likely to underperform the monthly returns of T-Bills.


These insights present significant difficulties for traditional, active investors.

First, there are very few “winners” for stock-pickers” to identify and invest in.

Second, for those investors who focus on the mean and variance of portfolio returns, effective portfolio diversification requires investing in a very large number of stocks to avoid missing out on the few winners – poorly diversified portfolios are all that is required to underperform, even before transaction sots and fees.

Third, even where an investor has performed well, the low number of strongly-performing stocks means that it is more difficult to ascribe the outperformance to skill than to luck.

So investors that want to capture the significant equity asset class risk premium are well-advised not to invest in active portfolios of a subset of the equity market – this is an enormously risky endeavour – and are far better advised to invest in a strongly diversified portfolio of almost all the equity market, such as is found in a wide-ranging index. This is even more true of smaller capitalisation equity securities.

A recent post on Philosophical Economics takes this concept further. If by moving from an active and relatively weakly-diversified portfolio (a traditional active approach) to an indexed and strongly-diversified portfolio (a modern passive approach), an investor reduces the expected volatility of his portfolio, then in theory he would also be willing to accept a lower future expected return.

The most straightforward way to achieve a lower future expected return is to start from a more highly-valued level. Thus it could be that one reason for the historically high valuation of the US equity market is in fact the trend to very significant passive exposures to the US market adopted by many investors in the US market, since the passive approach in fact a less risky way to invest in equities. In this way passive investing is a cause of higher valuations.