The Inefficient Market Argument for Passive Investing
Index fund proponents often argue in favor of passive investing because they believe that the modern U.S. equity market is informationally efficient. Market efficiency is the assertion that stock prices already reflect the best possible estimate of fair value, so there is no reason to actively buy and sell individual securities. However, for most investors, the assumption that the stock market is not efficient makes the argument for indexing even stronger. Even if prices routinely deviate from fair value, about two‑thirds of all active investors will underperform index funds every year. Further, if market prices are not efficient and investing is a matter of talent, then the investors in the underperforming majority will tend to be the same from year to year. Thus, indexing is preferred for most investors.
In addition to making the argument for passive investing given inefficient stock prices, this paper presents the following clarifications to conventional wisdom: 1) a high percentage of mutual funds underperforming the market index is not evidence that the market is efficient, and may in fact be evidence of an inefficient market; 2) as individuals and institutions opt out of active investing and index, the market may become more competitive, not less; 3) properly measured, about two‑thirds of all active investors will underperform index funds every year, independent of who chooses to actively invest, or the direction the market takes; 4) the proportion of small-cap oriented investors that must underperform small-cap indices is even higher than two-thirds, despite the fact that the small-cap sector may be less informationally efficient.
* Ph.D., CFA, H. Taylor Peery Professor of Financial Services, Marriott School, BYU.
Phone: (801) 422-6065 E-mail: email@example.com
The Inefficient Market Argument for...