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When indexing works and when it doesn’t – CBS News

(MoneyWatch) Myths are often created because there appears to be some data supporting the idea. One of the myths is that active managers outperform in some asset classes.

Nobel Prize winner William Sharpe put this to rest in his famous paper, “The Arithmetic of Active Management,” which simply said that, in aggregate, active managers must earn the same returns as passive managers before costs, but underperform them after costs, since they incur greater expenses. Despite the simple mathematical proof, the myth lives on. We’ll explore why that’s the case and also provide the “antidote.”

Dunn’s Law (named after a Southern California attorney that provided the insights) explains why sometimes it appears that active managers outperform in some asset classes. Dunn’s Law states that when an asset class does well, index funds will outperform active managers in that asset class. However, when an asset class does poorly, active managers have a greater chance to outperform their benchmark index, thanks to active funds drifting into better-performing asset classes.

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