In recent weeks the Wall Street Journal has been reporting on the increasing move to passive index investing as opposed to active management. As reason for the move, the Journal points to the inability of active managers to beat the market after taking account of the fees they charge. The implication is that the market is simply too efficient to justify active management fees. There are two, now somewhat ancient lines of academic research, that are still highly relevant to the issues investors face in the current environment.
First, in the early 1980s, Richard Roll and I and Joseph Stiglitz and Sanford Grossman demonstrated that markets can never be fully efficient. Market efficiency, after all, is not due to some natural phenomenon. It is the result of careful research by fundamental investors. If those fundamental investors cannot earn a fair rate of return on the resources they put into investment research they will cut back. But as fundamental investors cut back and indexing becomes more common, prices will begin to diverge from fair value making investment research more profitable. As a result, economic theory predicts that the market must be sufficiently inefficient to allow at least sophisticated investors to earn a fair return on their efforts by identifying mispriced securities.
Second, William Sharpe demonstrated that it is a mistake to equate market efficiency with the inability of active investors, as a group, to outperform passive indexes. A simple example illustrates why this is so. Divide investors into two groups: passive investors who hold the market index and active investors who engage in research in an attempt to beat the market. Suppose that in a given year the return on the market index is 10%. By definition passive investors who index the market will also earn 10%. But that means that active investors, as a group must also earn 10%, before costs. Given the costs of active investing, active investors as a group must always do worse than passive investors. As Sharpe stresses, this result has nothing to do with market efficiency – it is an arithmetic identity. Even in the most wildly inefficient market passive investors as a group would still outperform active investors as a group taking account of costs and fees. What is true is that if the market is highly efficient, so that few securities are mispriced, there is likely to be little superior or inferior performance among the class of active investors. Conversely, if the market is more inefficient then the more sophisticated investors, who can identify mispriced securities, will benefit at the expense of less informed active investors. But in either case, Sharpe’s arithmetic shows that active investors as a group will underperform passive investors, net of fees.
For investors who think they have the skill to identify mispriced securities, it would be nice to know if the current movement toward indexing has led to increased market inefficiency. Ideally, there would be an index of market efficiency that investors could use to judge how likely it would be to find mispriced securities. Unfortunately, there is no such index and there is not likely to be one in the foreseeable future. Asset prices are so volatile and market conditions are so variable that a reasonable index of “inefficiency” cannot be constructed. That is why, fifty years after Eugene Fama introduced the idea of market efficiency, scholars are still arguing about how efficient the market is. There is no evidence that the debate is subsiding. While conceptually it follows that the move toward passive investing will lead to greater inefficiency, whether there has been any material change in market efficiency thus far is unknown.