By William J. Bernstein, Efficient Frontier

"When an asset class does well, an index fund in that asset class does even better."
                              
                                                                                           -Steven Dunn     

One of the silliest bits of conventional financial wisdom is the notion that while indexing works well with the efficient U.S. large-cap market, there is benefit from active management in the "less efficient" small-cap and foreign arenas. In fact, Charles Schwab enshrined this dubious notion with its "Core and Explore" concept - index ("core") the former, and actively manage ("explore") the latter. This comforts greatly the legions of active-management-associated investment advisors and pension consultants, to whom it grants brief respite from the dustbin of financial history.

Obviously, the good folks at Schwab haven't yet heard the Gospel According to Dunn: that the fortunes of indexing a particular asset class depend on its performance relative to other asset classes. I’ve already covered this ground in a previous piece. John Rekenthaler also looked at the data from a somewhat different perspective (and, to my chagrin, came up with bigger t-stats than mine). For example, take a gander at the summary graph from his article:

Mr. Rekenthaler’s graph is a bit confusing since his y-axis is conventionally plotted, meaning that the best index performances are at the bottom (the best performers have the lowest numbers:1st percentile is the top percentile, 100th the worst). But it is quite clear that there is a strong relationship between how well the asset class does and how well indexing it works. In fact, if you closely examine his plot you’ll see that the relationship is curvilinear; there isn’t much difference between indexing the best and the middling asset classes. Index performance only begins to suffer with the very worst asset classes.

I've looked at Dunn's Law (DL) both in the U.S. and abroad. Bottom line: DL works very well domestically but not abroad, because of Rekehthaler's "Purity Theory": It's easy for a money manager to stray from his or her style box domestically, but harder for a foreign manager to stray across national boundaries.

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