There are two separate and distinct philosophies forming the basis of indexing investment strategies: the Efficient Market Hypothesis and the Costs Matters Hypothesis.
 

Efficient market hypothesis

The Efficient Market Hypothesis, EMH, suggests that by reflecting the informed opinion of the mass of investors, stocks are continuously valued at prices that accurately reflect the totality of investor knowledge and are fairly valued. This theory is founded on the belief that all investors have access to the same information so no-one can accurately predict which securities will outperform.

This theory is known as the Quantitative School of Indexing and is led by masters of mathematics such as Harry Markowitz, William Fouse, John McQuown, Eugene Fama, and William F. Sharpe. In essence, the Modern Portfolio Theory developed by the Quantitative School showed that a fully-diversified, unmanaged equity portfolio was the surest route to investment success.

Costs matter hypotheses

On the other hand, the Pragmatic School studied the evidence. In 1974, the Journal of Portfolio Management published an article by Dr. Samuelson entitled "Challenge to Judgment." It noted that academics had been unable to identify any consistently excellent investment managers, challenged those who disagreed to produce "brute evidence to the contrary," and pleaded for someone, somewhere to start an index fund. A year later, in an article entitled The Loser's Game, Charles D. Ellis argued that, because of fees and transaction costs, 85 per cent of pension accounts had underperformed the stock market. "If you can't beat the market, you should certainly consider joining it," Ellis concluded. "An index fund is one way."

The financial markets can be thought of as a zero-sum game, where one person's gain is another's loss. Before allowing for costs, the aggregate return of all investors in the market equals the market return. If index funds earn the market return, then actively managed funds, in the aggregate, must also earn the market return - before costs. Consequently, if some actively managed funds outperform the market, others must underperform the market by an equivalent amount.

After factoring in costs of investing, the aggregate return of all funds is less than the market return. Since index funds typically have much lower costs than actively managed funds, the result is that index funds have a higher aggregate return.

John C. Bogle, Founder and Former Chairman of The Vanguard Group, Inc. sums up this theory in The First Index Mutual Fund: A History of Vanguard Index Trust and the Vanguard Index Strategy where he writes: "Investors as a group cannot outperform the market because they are the market.

And from that theory flows the reality: investors as a group must underperform the market because the cost of participation - largely operating expenses, advisory fees and portfolio transaction costs - constitutes a direct deduction from the market's return."

Bogle calls this the Costs Matter Hypothesis. All managed funds have expenses, but some funds are much more costly than others, which directly impacts investment returns.