“Greater rewards, lower costs”


 Investment Philosophies, Theories and Practices (continued…)


The Inefficient Market Argument for Passive Investing           DOWNLOAD DISCUSSION...


By Steve Thorley , PhD, CFA, H. Taylor Peery Professor of Financial Services, Marriott School, BYU


Index fund proponents often argue in favour of passive investing because they believe that the modern U.S. equity market is informationally efficient. Market efficiency is the assertion that stock prices already reflect the best possible estimate of fair value, so there is no reason to actively buy and sell individual securities. However, for most investors, the assumption that the stock market is not efficient makes the argument for indexing even stronger. Even if prices routinely deviate from fair value, about two thirds of all active investors will underperform index funds every year. Further, if market prices are not efficient and investing is a matter of talent, then the investors in the underperforming majority will tend to be the same from year to year. Thus, indexing is preferred for most investors.


In addition to making the argument for passive investing given inefficient stock prices, this paper presents the following clarifications to conventional wisdom: 1) a high percentage of mutual funds underperforming the market index is not evidence that the market is efficient, and may in fact be evidence of an inefficient market; 2) as individuals and institutions opt out of active investing and index, the market may become more competitive, not less; 3) properly measured, about two thirds of all active investors will underperform index funds every year, independent of who chooses to actively invest, or the direction the market takes; 4) the proportion of small-cap oriented investors that must underperform small-cap indices is even higher than two-thirds, despite the fact that the small-cap sector may be less informationally efficient.


Before picking stocks, the individual investor faces several strategic decisions, including investing style, and how much of the total portfolio to allocate to equities. The growing availability of low-cost equity index funds and ETFs adds another strategic decision: whether to invest actively or passively. Active investing, historically the only alternative available, is the process of seeking out, or hiring someone else to seek out, the best stocks to buy. Implicit in this process is the assumption that some stocks are better buys than others, and that a diligent search can ferret them out. Indexing presents an increasingly popular alternative to active investing. An indexed fund includes all stocks in proportion to their capitalization in the market. All stocks in the market are included – there is no attempt to distinguish between good and bad investments.


The common justification for passive investing is that stock pricing in a competitive marketplace is informationally efficient. Financial economists who study the effects of competition sometimes conclude that all stocks will have the correct price all the time. The "correct price" in economic theory is defined as the best possible estimate of fair value based on currently available information. If a particular security is even slightly underpriced, diligent and ever vigilant investors will initiate buy orders that will quickly push the price up to its fair value. Similarly, the selling of overpriced stocks by informed market participants will immediately pull the price down. The controversial Efficient Market Hypothesis concludes that there is no point to fundamental or technical security analysis, because any stock is as good an investment as another. Active buying and selling of stocks by individuals will only run up brokerage commissions and waste time and energy. Turning to a professionally managed mutual fund is even worse, according to the Efficient Market Hypothesis, because of the fees required to pay well compensated experts to waste their time.


In contrast, I argue for passive investing under the assumption that the stock market is not efficient, so that some investments are simply better than others. The pragmatic motivation for this assumption is that it conforms to most investors' beliefs. Market rookies take up active investing based on the implicit assumption of pricing errors, while seasoned market veterans are often the most passionate critics of the Efficient Markey Hypothesis. For those inclined to accept the idea of market efficiency, it should be noted that this like most economic theory is based on the premise that people are perfectly rational, utility maximizing agents. If you have had any firsthand experience with people (or happen to be a person yourself) the assertion that people are always rational may be difficult to swallow. In fact, the growing field of behavioural finance is based on the proposition that people are consistently irrational in predictable ways...