Index Investing

Index Investing

Part 5: Efficient Market Hypothesis

In the last part we introduced index funds as an easy and cheap way to diversify your investments. But you can get diversification from other kinds of mutual funds and exchange-traded funds (ETFs) beyond index funds. I jumped straight to index funds though because they’re the best choice.

The reason why has to do with the efficient market hypothesis, which states that prices of stocks reflects all the information about the stock at a given time. If the current price already accounts for everything known about a company’s prospects for the future, then it’s impossible to out-perform the market just by choosing which companies to invest in – the only way to possibly do any better is to take more risk, which has the natural downside of taking more risk.

The Similarity of Impossible and Very Hard

The efficient market hypothesis in its purest form is a little hard to swallow: if nothing else, we’ve seen some great investors over the years. The existence of Warren Buffet should suggest that it isn’t impossible to out-perform the market. It’s also hard to accept that the market could possibly be efficient: even if all the information about a company was widely known, people will disagree on how to interpret and weight that information to come to

There are some other anomalies, including large-scale events like past bubbles and crashes to funny anecdotes like cases of mistaken identity that make the efficient market hypothesis a touch controversial. One of those anecdotes was when a small company called Zoom Technologies briefly sextupled in March of 2020 as some investors apparently mistook it for the much better-known Zoom Video Communications, which makes the video calling software everyone suddenly found themselves using the midst of the global pandemic. And that wasn’t the first time that had happened to Zoom Technologies – it more than tripled the year before as the more popular Zoom was going public.

While these exceptions may indicate the market isn’t completely efficient and that it’s not impossible to out-perform, that doesn’t mean it’s easy to do.

I myself believe in a weaker form of the efficient market hypothesis, that prices mostly reflect available information and that it’s thus very difficult to out-perform the market. But that leads us to the same place: whether it’s impossible or merely very difficult to out-perform the market is a minor quibble in the real world. For someone who doesn’t want to up-end their lives to become a professional investor the path forward in either case is the same: invest in the market as a whole through low-cost index funds.

Evidence that Active Management is Hard

While it’s hard to prove that the market is absolutely efficient, there is a lot of evidence that it is at the very least very difficult to beat. That doesn’t stop many investors from trying, and there is a whole industry of mutual funds where the sales pitch is that the professional managers will provide superior performance for their investors.

Mutual funds provide a lot of readily available data for how professional managers who do try to pick winning stocks (or avoid losers) perform against their index benchmarks. And study after study confirms the same thing: net of fees, active management largely under-performs a comparable passive index.

The S&P Indices Versus Active (SPIVA) reports are published regularly, comparing how actively managed mutual funds compare to their benchmark. The most recent report (mid-year 2020) shows that almost 90% of Canadian equity funds under-performed their benchmark over the past decade. Those are not great odds, especially as there is no way in advance to pick the 10% or so that might have out-performed: past performance isn’t predictive (and almost all advertising contains that key phrase “past performance may not be repeated”), nor is a degree from Rotman, Schulich, nor even Ivey.

The best, most reliable bet then is to choose the average of all of them – via index funds. Which is a little counter-intuitive: if the index measures the “average” stock return, and basically all of the active managers together end up summing to the index, then shouldn’t the index’s return be somewhere in the middle of the pack? The key point is “net of fees” in the studies – through management fees and trading costs, active funds generally sap their performance, which is an important point that we’ll cover in the next article. Indeed, the best predictor of how well a fund will do is its fees – with lower fees being better.

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