The Efficient Market Hypothesis, which was awarded the Nobel Prize, implies investors should prefer index funds over actively-managed funds. We examine the theory and the evidence. And remember a friend.
In the 1960s, Dr. Eugene Fama proposed the Efficient Market Hypothesis, or EMH. It says the price of a company’s stock reflects all the information relevant to the value of the company. One implication of the theory is stock prices are not predictable (because to predict a stock’s price, one would need information pertinent to the value of the company but not yet impounded in the stock’s price).[1], [2]
Let’s now bring the most popular investments vehicle of all, mutual funds and exchange-traded funds, into the conversation. There are over 12,000 such funds registered in the U.S. Of these, the vast majority are actively-managed, which means they try to deliver an investment return higher than that of a randomly-picked basket of stocks with the same risk by attempting to predict stock prices. In other words, they attempt to beat their benchmarks by stock-picking. What does the EMH say about actively-managed funds? It predicts they earn the same return as a basket of randomly-selected stocks minus the expenses incurred managing the fund (including the costs of maintaining a staff of stock pickers). In other words, it predicts they will underperform their benchmarks to the extent of their fees.
That’s the theory; what about the evidence? In the decades since its conception, a substantial body of evidence has accumulated validating the EMH. This includes strong evidence that actively-managed funds underperform their benchmarks. In fact, the evidence against funds, gathered from precise measurements of fund performance, appears overwhelming. This has influenced the way millions of people invest, contributing to the popularity of index funds—funds which do not try to beat the market, but instead replicate the market by holding broad, diversified baskets of stocks.
Dr. Fama won the Nobel Prize in Economics for the EMH in 2013. Since then, the evidence against actively-managed funds and for index funds has only kept mounting. The implication of the EMH and five decades of evidence which confirm the theory is investors should select index funds instead of actively-managed funds.
So what does an investor gain by selecting an index fund instead of an actively managed fund? Around 1.5% per year. And what kind of funds do you think Freshfield uses to build client portfolios? You guessed it.
What about the friend? He is the late Dr. James MacBeth, a friend, mentor and colleague who guided me through an undergraduate degree and two graduate degrees. Dr. MacBeth was a world-renowned economist whose doctoral committee chairman at the University of Chicago was our Nobel Laureate, Dr. Eugene Fama. Drs. Fama and MacBeth engaged in ground-breaking research which showed that investment returns were systematically related to investment risk.[4] In effect, Drs. Fama and MacBeth were the first to confirm empirically that investors required a higher return for taking on higher risk. Their article documenting their findings remains among the most cited articles in all of financial economics.
Dr. Andy Lawson is the principal of Freshfield Investments, a Registered Investment Advisory firm in Plano, Texas serving clients locally and nationwide. Freshfield provides investment management and financial planning as a fee-only, fiduciary. To book a virtual or in-person complimentary consultation, please visit our Contact page.
I am grateful to Pamela Bodkin, Carol Doughty and Alexandra Sukhoverko, Bank of Texas for their suggestions and advice. Any errors are my own.
[1] To illustrate, imagine you are aware a pharmaceutical company is about to release a highly profitable new drug onto the market for which there will be strong demand. The only way this information could lead to a price increase in the company’s stock is if the stock market is as yet unaware of this information, and it is therefore not yet reflected in the company’s stock price (which is not allowed by the theory).
[2] 1970b, Efficient capital markets: A review of theory and empirical work, Journal of Finance 25, 383-417
[3] 1991, Efficient capital markets II, Journal of Finance 46 no. 5, 1575-1617
[4] Fama, Eugene F.; MacBeth, James D. (1973). "Risk, Return, and Equilibrium: Empirical Tests". Journal of Political Economy. 81 (3): 607–636
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