The Efficient Market Hypothesis (EMH) has been around for more than 50 years. Academics and investors alike have differed on its merits, and many financial organizations have built their businesses based solely on this theory. Index fund and ETF companies in particular have profited handsomely over the years from the proliferation of this idea. But does indexing really benefit investors?
For those unfamiliar, the EMH claims that since markets are efficient, share prices will always reflect underlying value accurately. In other words, it is no use making any value judgments of equities since the current price is already reflecting all information about the company and discounting its future earnings. It claims that fundamental and technical analysis of equities is useless and that investors would be better off if they just bought a fund that mirrored an index since its transaction costs are less. It concludes that active stock investing is no more effective than picking stocks at random.
Do stock funds as a whole beat the market averages? The answer is no they don’t. But this may not necessarily be an indictment of active versus passive investing, but more a problem with the stock fund paradigm itself. Stock mutual funds and exchange traded funds tend to be broadly diversified and I will postulate that this is more of a detriment than a benefit. When the entire stock fund universe is compared with the market averages the return is a few percentage points less. This slight under-performance is most likely due to increased transaction costs rather than poor stock picking skills. It does not prove that random stock selection is better than judgment based selection. This is where their reasoning falls apart. Proponents incorrectly assume that the slight under-performance of actively managed stock funds points to the superiority of passive index investing over any other approach. But the reality is that this anomaly exposes the mediocrity of both index funds and actively managed stock funds. It simply proves that too much diversification causes average results. The reason why actively managed stock funds seldom beat the averages is because of over-diversification and because they must buy high and sell low.
Think about it. The more a stock fund diversifies its holdings the more its results will mirror the averages. Broad diversification also eliminates any advantage a skilled manager brings to the table. A minimum amount of diversification is both necessary and wise to reduce risk, but too much is a recipe for mediocrity. There comes a point of diminishing returns whereby superior performance becomes merely average.
The question we should be asking is can managers who invest in multiple asset classes of their own choosing beat the stock market averages? The answer is a resounding yes. We know this because it has been done. The fact remains that many managers including Warren Buffett, Ray Dalio, Seth Klarman and others have indeed performed this feat. Proponents of efficient markets argue that these managers are simply outliers and that the general theory is sound. I would argue that the EMH only applies to stock fund managers. In other words, efficient market theorists are correct when they claim managed mutual funds will be at a slight disadvantage to index funds, but they are incorrect when they assume that index fund investing achieves better results than concentrated stock portfolios or multiple asset class managers. Balanced investors can not only beat the market averages, but the odds are significantly in their favor.
This has more to do with the constraints placed on stock fund managers rather than their investing acumen. New money coming into the fund has to be invested in equities. The manager has no choice, even at the height of a bull market when stocks are trading at high valuations. Likewise, at the bottom of a bear market when there are a lot of redemption requests, he has to sell to meet the withdrawal demand. He has no choice. By nature of the beast he has to buy high and sell low. This is magnified even further during times of extreme euphoria or despair. This explains why stock funds tend to mirror the market averages.
Stock fund managers also have concentration constraints. In many cases they cannot have more than 2% of their assets in any one company. Even if they come across an opportunity where an excellent company is available at an attractive price, they won’t be able to take advantage of it if they are fully invested.
On the other hand, the balanced fund manager who can buy any asset class he chooses has a lot more leeway. At the height of a bull market he doesn’t have to put new money into stocks, he can buy bonds or just park it in cash. Likewise, at the bottom of a bear market with a lot of redemptions pending he doesn’t have to sell stocks. He can liquidate a portion of his bond portfolio instead. The balanced fund manager can really buy low and sell high.
Broadly diversified stock funds generally do no worse or better than the market averages. Over time they will more than likely mirror the averages minus transaction costs of course. I feel a little sorry for stock fund managers whose performance is constantly scrutinized and compared with the market averages. If they have a bad year they will be replaced even though their stock picks were sound for the most part.
Another incorrect assumption promoted by the efficient market theory is that fundamental analysis is of no value whatsoever and that everyone should just buy an index fund and go on vacation. I challenge this notion. Again, the theory postulates that managers who pick stocks using research and judgment can do no better than stocks picked at random or a chimpanzee who just throws darts at the financial pages. This is flagrantly false.
Let’s take a hypothetical example. Suppose you have two companies who engage in the same business. A commodity wholesaler for instance. They sell the same commodity to the same geographic market. But one company has a 90% debt to equity ratio and the other has only a 10% debt to equity ratio. Which company will fare better over time? All things being equal, the company with less debt will do better. Of course in practice all things are not equal, but you get the idea. Fundamental analysis can make a difference especially when there are glaring and obvious discrepancies.
Indexing itself may not be the miracle investing strategy that its proponents claim. Maybe at first it was, especially in the 1970s when few people were doing it. But like other investing schemes of the past, the more people who engage in it the less effective it becomes. Take the S&P 500 for example. It is the most indexed group of stocks in the entire world. People who buy into an index fund that mirrors the S&P 500 live and die by the stocks in that index. A company that gets promoted by Standard & Poors into the index will get an immediate bump in their share price. All the index funds in existence will suddenly buy this stock. Therefore, the more index funds there are in relation to other stock funds, the more overvalued the index tends to be. Likewise, if a stock gets demoted from the index it will take a hit, and the more it is indexed the bigger the hit will be.
At the height of a bull market S&P 500 stocks tend to be more overvalued than lower-cap stocks. This is primarily due to the proliferation of indexing. Mere membership in the S&P 500 can artificially prop up share prices despite underlying business conditions. That may be fine and dandy during a bull market, but when the next bear market strikes, heavily indexed companies will get hammered even harder than lower-cap issues.
Index funds and actively managed stock funds are basically the same animal as far as results go. Equity fund investing by itself, either active or passive, is no match for the multi-asset class manager with sound judgment who can competently assess value. Investors should look more into balanced fund managers and compare their results to the market averages before investing solely in stock funds.