  We develop a simple stock selection model to explain why active equity
managers tend to underperform a benchmark index. We motivate our model with the
empirical observation that the best performing stocks in a broad market index
often perform much better than the other stocks in the index. Randomly
selecting a subset of securities from the index may dramatically increase the
chance of underperforming the index. The relative likelihood of
underperformance by investors choosing active management likely is much more
important than the loss to those same investors from the higher fees for active
management relative to passive index investing. Thus, active management may be
even more challenging than previously believed, and the stakes for finding the
best active managers may be larger than previously assumed.
