Efficient Markets

A cornerstone of indexing advocates is based on securities markets being efficient. Barron’s defines the efficient markets theory: “…market prices reflect the knowledge and expectations of all investors. Those who adhere to this theory consider it futile to seek undervalued stocks or to forecast market movements. Any new development is reflected in a firm’s stock price, making it impossible to beat the market.” This vociferously disputed hypothesis also holds an investor who throws darts at a newspaper’s stock listings has as good a chance to outperform the market as any professional investor. The theory, also known as the random walk theory, was first set forth in 1900 by the French mathematician Louis Bachelier, and received modern treatment in Burton Malkiel’s book, A Random Walk Down Wall Street. Most years, the majority of active fund managers underperform market indexes, adding support to the efficient markets hypothesis.

 

An article by DiTeresa (1999) contains an interview with George Sauter, a Vanguard fund manager who oversaw its flagship S&P 500 Index Fund as well as an actively-managed Vanguard mid-cap fund: “Indexing’s key advantage is long-term performance. Look at the Morningstar style-box categories and you’ll find that in every one, indices beat the majority of funds over the long haul….investing is a zero-sum game.” Haslem (2003) believes indexed funds should comprise 80-90% of a securities portfolio.

 

Legendary Legg Mason fund manager Bill Miller has a refreshing perspective on active vs. passive investing by pointing out no one buys an average-performing fund and that there are a number of funds whose returns have beaten the S&P 500 over time. For 10 consecutive years, Miller outperformed the S&P 500. While he believes the stock market is efficient over time, he also believes there are times when it is not efficient. Miller is particularly attracted to mispriced securities. He describes the S&P 500 as “a very successful actively managed portfolio.”

 

Dziubinski (1998) and DiTeresa (1999)

Studies by Dziubinski and DiTeresa state there is a role for both active and passively managed funds. DiTeresa (1999) favors indexing for large caps; the author appears to have no preference for selected active management or indexing when it comes to other U.S. and developed stock markets. DiTeresa does lean toward active management for regional and emerging markets. Conversely, Dziubinski favors active stock management when the fund has: [1] < 50% annual turnover, [2] 50-60% of assets in two sectors, [3] 30%+ of its assets invested in its 10 largest holdings, and [4] a small expense ratio.