Passive investing and the paradox of efficient markets

Eugene Kaganovitch
— 1 minute read

Active managers won't be declared an ‘endangered species’ any time soon, but one thing is clear – sooner or later, their business model will have to change, writes Synchronised Investments' Eugene Kaganovitch.

eugene kaganovitch

Active managers analyse stocks in an effort to pick undervalued companies. It requires time, skill and knowledge. Passive managers, on the other hand, simply invest according to the index.

Index investing is not a new concept and it took decades to bring it into the mainstream. As John Bogle, founder of the world's first index fund, recalled, “Forty years ago, the concept of index investing was broadly regarded by the investment community as trivial and likely to fail.”

The first index fund was launched in 1976 but it was only in the late 1990s that it achieved general acceptance within the industry as a valid approach to investing.

There are plenty of arguments on both sides, but ultimately the question is, “Does the knowledge and skill of active managers bring superior results, thus compensating for the additional cost?”

It would be logical to assume that skill and experience provides active managers with an advantage, as with any other profession.

However, there is substantial evidence demonstrating that this is not the case. For example, according to a report by Morningstar, from 2004 to 2014, actively-managed funds lost out to index funds in nearly every asset class.

The standard explanation for this phenomenon is the efficient market hypothesis – by the time you turn around to buy a stock, its price has already incorporated all publicly available information.

But does it really reflect market sentiment or fair value? In other words, is the market a popularity contest or a sound mechanism for measuring the shareholder value?

As the father of value investing, Ben Graham, famously put it, “In the short run, the market is a voting machine, reflecting a voter registration test that requires only money, not intelligence or emotional stability. But in the long-run, the market is a weighing machine.”

That makes sense. Otherwise, why would the market index grow over time if not due to the economic growth of the listed companies, as reflected by their stock prices?

Let's take a closer look at the market. Surely, it is not some ‘magical device’, separate from investors, which generates movement within the index. In fact, it comprises the very same participants who are failing to outperform it.

It's not hard to identify the following segments of the market:

  • Professional managers running actively-managed funds
  • Professional managers running index funds
  • Individual investors investing directly in the share market
  • Individual investors investing in actively-managed funds
  • Individual investors investing in index funds
  • Stock traders

How do these market segments contribute to the market's ‘weighing machine’?

Clearly, traders are not contributing very much. For them, a stock is just a blip on their computer screen.

Equipped with historical price movement charts and driven by market sentiment, they are trying to predict (and take advantage of) the market's reaction to the news, and are not really concerned with the business fundamentals behind the stock symbols.

Individual investors are not very different in this respect. Though many of them are interested in picking undervalued stocks, they generally do not have the time and/or skills to do it properly and consistently.

A share's price is the result of interactions between large numbers of market participants, but the only segment of this population which can reasonably be considered as the prime mover in directing share price towards its fair value would be the active managers.

Obviously, different managers have different styles, methodologies and interpretations of events, but collectively, they make the market a ‘weighing machine’.

Individual investors and traders are not directing share price towards its fair value.

Paradoxically, individually, active managers struggle to outperform the market but collectively, they ensure that share price reflects fair value.

Advocates of passive investing are succeeding in making their message heard and the pendulum is now swinging towards index funds. As mentioned by Mr Bogle, the market share of index funds grew from 16 per cent in 2005 to 34 per cent in 2015.

And even among active fund managers, quiet “index hugging” is rampant.

The appeal of passive investing reaches far beyond managed investments. In our opinion, its simplicity is one of the main reasons for the rise of robo-advice.

Although seemingly unrelated spheres, one paved the way for the other. Various algorithmic software applications existed long before robo-advice became the darling of the fintech industry, but they were too complex and too unpredictable.

Robo-advice is a risk-assessment tool (using a questionnaire) combined with automated selection of ETFs, and its simplicity and transparency works well with passive investing.

Active managers can exist only if indirect investors put their money in actively-managed funds. If the current trend continues and investors desert active managers en masse, switching to passive investing, the number of active managers will decline.

Imagine a market dominated by traders and individual investors whose decisions are driven primarily by momentum, perception, popularity and so forth.

The possibility of this happening may sound very remote but if it does happen, will the index keep growing over time or it will be prone to wild swings? (Not unlike the wild swings in the weather we've been experiencing lately!)

It may be interesting to note that things are looking up for active managers, if you consider their returns before their fees are factored in.

According to research carried out by Nobel laureates Eugene Fama and Kenneth French, “When returns are measured before the fund expenses borne by investors, we find evidence that there are true winners in the population of fund managers.”

Eugene Kaganovitch is the co-founder and director of Synchronised Investments.



Passive investing and the paradox of efficient markets
eugene kaganovitch
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