When Indexing Works and When It Doesn’t in U.S. Equities: The Purity Hypothesis

Abstract

Conventional wisdom says that domestic equity indexing is more likely to outperform active managers in efficient markets like large stocks and is more apt to underperform active managers in less efficient areas like small stocks. But data from 1998–2007 does not support this idea. Instead, 1998–2007 data show that domestic equity indexing tends to outperform active management in the highest-returning asset classes and tends to underperform active management in the lowest-returning asset categories. This concept is called the Purity Hypothesis. The Purity Hypothesis held true for the 10-year period ended 2007 for the S&P, MSCI, Russell, and Morningstar domestic equity indexes. But its effectiveness on a single-year basis during this time varied by index provider.