Market Efficiency and the Impact of Passive Investing

Market Efficiency  being impacted by the rise of passive inflows?In recent weeks the Wall Street Journal has been reporting on the increasing move to passive index investing as opposed to active management.  As

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.

Market Efficiency ETF Liquidity Rules The Rise Of ETFs And Passive Investing

Market Efficiency

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.

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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.

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About the Author

Brad Cornell
Bradford Cornell is a emeritus Professor of Financial Economics at the Anderson School of Management at UCLA. Prof. Cornell has taught courses on Applied Corporate Finance, Investment Banking, and Corporate Valuation. Professor Cornell received his Masters degree in Statistics and his PhD in Financial Economics from Stanford University. In his academic capacity, Professor Cornell has published more than 125 articles on a wide variety of topics in applied finance, particularly empirical analysis of asset pricing models. He is also the author of Corporate Valuation: Tools for Effective Appraisal and Decision Making, published by Business One Irwin, The Equity Risk Premium and the Long-Run Future of the Stock Market, published by John Wiley and Conceptual Foundations of Investing published by John Wiley. He is a past Director and Vice-President of the Western Finance Association and a past Director of the American Finance Association. As a consultant, Professor Cornell has provided testimony and expert analysis in some of the largest and most widely publicized finance related cases in the United States. Among his clients are: AT&T, Berkshire Hathaway, Bristol-Myers, Citigroup, Credit Suisse, General Motors, Goldman Sachs, Merck, Microsoft, Morgan Stanley, Orange County CA, Price Waterhouse, Verizon, Walt Disney and various agencies of the United States Government. Professor Cornell is also a senior advisor to Rayliant Global Investors and to the Cornell Capital Group. In both capacities, he provides advice on fundamental investment valuation. In his free time Prof. Cornell enjoys cycling and golf.