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"The Inefficient Markets Argument for Passive Investing" by Dr. Steven Thorley
By Rahul Seksaria
1999

Conventional wisdom justifies an indexing strategy based on the assumption that markets are efficient. The large-cap sector, considered informationally efficient, has accounted for an astounding majority of the indexed investments. But Dr. Steven Thorley, Associate Professor at the Marriott School at Brigham Young University, argues that for most investors, an inefficient stock market is more of a reason to index their investments.

A condensed verion of his research paper is presented below:

The controversial Efficient Market Hypothesis concludes that there is no point to fundamental or technical security analysis because all stocks are fairly priced. Active buying and selling of stocks adds no value, instead runs up brokerage commissions. Turning to a professional manager is even worse because of the fees required to pay well compensated experts to waste their time. Indexing becomes a better alternative under these circumstances. For most investors though, an inefficient stock market (one with frequent mispricings) makes the case for indexing even stronger. The discussion that follows assumes that stock prices are sometimes wrong and focuses on the competition among investors attempting to identify these mispricings.

The logic of passive investing

If the stock market is assumed to be a skill-based game, those with the skill and resources to identify and act on market inefficiencies will probably do well. Consider a free-throw competition in which you get a dollar for every shot you make, but instead of actively participating in the game, you can take the average score of those who do. Passive investing is analogous to sitting on the sideline and taking the average score.

If you believe that you have lower than average skills, then it would be better to sit out, but if everyone takes this more rational approach then only top half of the skill pool would shoot. From this more rational perspective, you should play only if you are in the top 25 percent of the players. But if everyone took this approach, only the best player would eventually shoot and the rest would get his/her score. But investors are not quite so rational in their approach, mainly due to their overconfidence. But it is amply clear that at least half of all active investors would be better off indexing.

Misconceptions about market competition

Before going on to the pros and cons of active investing, it is essential to clear investors' two major misconceptions about market competition.

It is a well-known fact that more than half of all active mutual fund managers underperform the market. This is often interpreted as proof of market efficiency. But the fact is that mutual fund managers consistently underperform the market by more than can be accounted for by the extra costs of active management. This in fact is proof that investing is a skill-based game and that active mutual fund managers, as a group, have below average skills.
Another misconception is that active investors will be better off if more people use an indexing strategy. But the fact of the matter is that when novices leave the active arena to index, the average skill level of the active players rises. The exit of lower skilled players would thus increase the competition among the active investors in their search for bargain stocks.

Costs of Active Management

There are four extra costs associated with active investing versus passive investing:

Transaction Costs: Brokerage commissions and bid-ask spreads detract a lot more from the performance of active funds due to their much higher frequency of trades. A rough estimate puts it at a little over one percent a year.
Tax-Inefficiency Cost:Active trading is tax-inefficient as capital gains are due each year as stocks are bought and sold under active management. Placing a number on this cost is difficult as individual tax status and tax rates differ, but a quick and dirty estimate is at least one percent a year.
Undiversified Risk Cost: Sub-optimal diversification of an active fund adds risk to a portfolio that could have been avoided by investing in an index fund. This risk cost is estimated to be about one percent per year, similar to the transaction and tax costs.
Research Cost: Analyzing and identifying stocks to invest in requires a substantial amount of time and effort. These research activities can be self-performed, but it would be hard to compete, from an opportunity-cost perspective with a specialist's expertise and economies of scale. Most mutual fund managers charge between one and two percent of assets under management as research fees.

These four costs of active management result in about a four percentage point handicap per year, compared to passive investing.

Benefits of Active Management

Investors enjoy the intellectual challenge of active investing and the satisfaction of sometimes winning a skill-based game. But the following discussion assumes quite rationally that an investor's decision to be an active investor is based on the potential for financial rewards.

All stocks have to be held by someone, and the average before-cost performance of all active investors each year must equal the market index's return. This realization can also be used to measure the distribution of active management results around the average.

A computer simulation was conducted of ten thousand portfolios of twenty stocks for each of the last ten calendar years. The probability of a stock being included in a portfolio equaled its capitalization divided by the entire market capitalization since more investment dollars are devoted to larger-cap stocks. In 1996, the average before-cost return of the ten thousand portfolios was 21.86%, very similar to the market return of 21.82% as represented by the Russell 3000. The return on index funds would be slightly less due to tracking errors and the nominal fees charged to manage the funds.

For an assessment of the after-cost returns on the simulated active portfolios, the liberal assumption was made that any individual investor only bears three of the four costs of active management. Assuming active management costs to be approximately 3 percent, the average after-cost return on the simulated portfolios was 21.86 - 3 = 18.86%. Under this assumption two-thirds (6,654 out of 10,000) of the portfolios underperform total-market index funds on an after-coast basis.

The results in other years are similar to the 1996 simulation. Under the assumption that performance returns are normally distributed, these numbers dictate that about two-thirds of all active investors will underperform an indexing alternative each year on an after-cost basis. This means that you must be in the top one-third in order for active management to pay off.

In the small-cap arena, the proportion of active investors outperforming a small-cap index fund would even be lower because active investing in small-cap equities involves higher transaction and research costs. This deduction contradicts conventional wisdom that active managers can do better in the less-efficient small-cap market. However, the percentage of players that mathematically must underperform any given index is dictated by the range of performance outcomes and active management costs, not the informational efficiency of the market that the index tracks.

The top third

So what motivates the bottom two-thirds to remain in the game? One explanation is that investors view the stock market as an entity in itself and mistakenly conceptualize it as a place where everyone can be above average if they are bright and work hard. Another argument is that, while investors recognize the stock market is a competitive environment, they are overconfident about their own skills.

The above discussion leads us to the question: Which investors/investor groups are most likely to be in the coveted top third in terms of skills, information, or other competitive advantages? Mutual fund managers, as a group are definitely not in the top third. Two other investing groups, insiders and hedge fund managers, both of which have identifiable competitive advantages, are more likely candidates to be in the top third. Identifying a competitive advantage possessed by individual investors is difficult, though this clearly does not dissuade them from active management. Why play a game in which your competitors have an advantage, if you can win more often than not by staying out of the game?

The unavoidable conclusion

If prices in the stock market are not efficient and investing is a skill-based game, then low-skilled investors will consistently lose to players with a competitive advantage. If, on the other hand, you assume that the market is perfectly efficient, then the less-skilled players have the same one-in-three chance of beating the index as everyone else. Market efficiency protects the less-skilled players from routinely making bad investments. There is, however, no such protection in an inefficient market, and so the active investing majority that underperforms the index will tend to be the same every year. The argument for indexing is even stronger for most investors if the stock market is not efficient.

About two-thirds of all active investors, whose only financial justification for being active is beating the index, must fail in that objective each year. The two-thirds failure rate is as mathematically certain as the forecast that exactly half of the workforce will earn less than the median income. Each active investor should therefore confront both the question: Am I in the top third of everyone who thinks they are? And the unavoidable answer: Probably not.