Passive investing, index funds, inefficient markets

Steven Thorley, Associate Professor and Finance Group Leader, the Marriott School at BYU, wrote an interesting paper in 1999. He argues that markets are inefficient. An inefficient market is one in which stock price does not always reflect fair value. Investors make money in an inefficient market by finding and investing in these “mistakes”, these stocks that are valued incorrectly.

The conclusions he draws are rather interesting. One is that making money as an active investor will become more difficult:

If active investing is a skill-based game, then skilled players will be worse off when lower skilled investors choose not to play. As an active investor, your ability to outperform the indexing alternative (be better than average) depends on the participation of players with below average skills. Someone has to buy the stock you want to unload at a higher than justified price, and sell the stock you want to buy at a bargain. Someone has to be wrong in order for you to be right.

The author believes that many active investors don’t realize this. Some simply don’t understand that the stock market is a competitive place where some people have to lose in order for other people to win. Other people realize this but continue investing actively because overconfidence blinds investors to the fact that about 2/3 of them would be better off indexing.

Thorley’s argument that markets are inefficient (and that investing is a competition won by skilled players) also shows the folly of investing in actively managed mutual funds:

In fact, when a given category of investor, for instance, mutual fund managers, consistently underperforms the market by more than can be accounted for by the extra costs of active investing, then some other category of investor must be consistently outperforming the market. The percentage of actively managed mutual funds that underperform the market has been reported as high as 95 percent. If this number is accurate and persists over time, then it is evidence that the market is a skill-based game, and that active mutual fund managers, as a group, have below average skills. If investing is a skill-based game, then prices in the stock market are not efficient.

The Great Mutual Fund Trap by Gregory Baer and Gary Gensler, former officials of the U.S. Treasury covers the topic of actively managed mutual funds in great detail while arguing that passive investing is the right approach for individual investors. The argument is a convincing one: over every five-year period only about 20% of actively managed mutual funds perform well enough to make up for their fees and expenses.

That doesn’t mean, investors should go pick one of the few funds that has outperformed the past 5 years. Picking a winning fund is not so simple. The authors show that funds that outperform for one five-year period are likely to underperform for the next five years! By the way, The Great Mutual Fund Trapalso calls for investors to avoid day trading, and stock-picking. Instead, investors should buy funds with low fees and expenses. The Vanguard Total Stock Index and 500 Index funds are the authors’ favorites. They also encourage investors to consider ETFs, focus on asset allocation, buy bonds directly from the government, and invest in tax-advantaged accounts like Roth IRAs for retirement and 529 plans for education expenses.

Thorley also notes that active investing is a more expensive game to play than passive investing. Transaction fees, capital gains tax (not an issue for some retirement accounts), time and effort (you either do the research yourself which may come with expenses such as using Morning Star or Motley Fool or you pay someone else – like a mutual fund manager – to do the stock picking for you). Active investors have less diversification and therefore, greater risk.

Of course, to be fair, we have to mention the benefits of active investing. It’s more fun, especially if you win (although when you lose it can be awfully stressful), than passive investing which is always boring. People with inside information can beat the market (this may not be legal, but it’s not uncommon). So can people who are more skilled than 2/3 of active investors. Here the author reminds us that 80% of drivers feel they are among the top third in driving skill. Thorley argues that most active investors make a similar mistake when it comes to evaluating their investing skill.

There is one final point to consider: size.

Size may be the one competitive advantage of the individual investor, because pricing errors on very small or illiquid stocks can not be exploited by large institutional investors. Either the market order itself will be so large that the pricing error evaporates as the order is executed, or the position taken will be too small to materially affect the bottom line of a large pool of money. The significance of this individual investor advantage is debatable, given the relatively high costs, both research and transactions, of active management in the small-cap market.

This means that maybe a small investor can take advantage of a situation that an insitutional investor would never bother with. To do your own research, buy The Great Mutual Fund Trap and check out Thorley’s paper online.

One Response to “Passive investing, index funds, inefficient markets”

  1. Ewing says:

    Thanks for the interesting article! I agree that the market is often inefficient, and the more skillful will benefit at the expense of those not skilled. However, the stockmarket is not always a zero-sum game: If a stock rises from $10 to $50, and investor A sells it to investor B mid-way at $25 to buy a house, then both have made profits. It is not zero-sum if for each person this trade represents their best investment option.

    Again, good article!