By Jason Zweig | Jan. 11, 2012 11:24 am ET
Image credit: “Chimpanzee at Typewriter, New York Zoological Park” (1907), Wikimedia Commons
Over many years of writing about investing, I’ve probably heard at least 500 money managers say that their funds were sure to deliver fat returns because they invest in markets that are “inefficient” or “less efficient.”
Only giant stocks like Apple or Johnson & Johnson, whose shares are followed by dozens of analysts and traded by the millions every day, are supposed to be efficient.
On the other hand, small companies, real-estate investment trusts, stocks followed by only a few analysts, stocks with share prices under $5, emerging markets like India or “frontier markets” like Nigeria — all these are supposed to be “inefficient.”
In theory, for “inefficient” investments, there is a shortage of informed buyers and sellers. So, say the money managers who make this argument, the prices of these stocks get set by people with incomplete or biased information—the very definition of market inefficiency.
But none of this adds up, says finance professor Ken French of Dartmouth College and a director of Dimensional Fund Advisors. Considering how cheap it has become to trade stocks, the hundreds of millions of investors competing over them every day and the massive amounts of research generated around the world, it isn’t very likely that screaming bargains will go unheard or that absurd overvaluations will persist for long.
Also, when shares are thinly traded, they are more expensive to buy and sell. So any mispricing has to be substantial before anyone will step in and trade on it.
Furthermore, as I wrote two years ago, markets can be inefficient and invincible at the same time. An inefficient market can be more prone to extremes of euphoria and misery. Instead of buying low and selling high, even experts may end up buying high and selling low — especially when emotions are at their most intense.
If it were true that money managers can more easily beat inefficient than efficient markets, then the differences would be easy to see.
But that’s not the case.
Twice a year, Standard & Poor’s calculates what percentage of funds in various categories have outperformed the relevant market benchmark. Consistently, the funds pursuing opportunities in “inefficient” markets like small stocks, real estate or emerging markets don’t look any better than those investing in the biggest U.S. stocks.
If anything, they do even worse!
Over the three years ended in mid-2011 (the most recent data available), 64% of large U.S. stock funds failed to beat the S&P 500, according to S&P. Among small-stock funds, 63% lagged S&P’s index of small stocks, while 66% of real-estate funds underperformed their relevant benchmark and 81% of emerging-markets funds lagged the index of stocks in developing countries. Over five years, those gaps get even worse.
The standard advice — buy index funds for your “efficient” large stocks but actively-managed funds in the “inefficient” remainder of the market — doesn’t seem to have much evidence behind it. A truly inefficient market is hard to find.
Definitions of EFFICIENT MARKET HYPOTHESIS and INDEX FUND in The Devil’s Financial Dictionary
For further reading:
“Whether Markets Are More Efficient or Less Efficient, Costs Matter” (John C. Bogle, Vanguard)
“The Arithmetic of Active Management” (William F. Sharpe)
“Index Investing Makes Markets and Economies More Efficient”(“Jesse Livermore,” Philosophical Economics)
“The Dunn’s Law Review” (William J. Bernstein, Efficient Frontier)
“Where Active Management Succeeds (or Fails)” (John Rekenthaler, Morningstar)
“Are Markets Efficient?…And Does It Matter?” (Michael W. Nolan, Vanguard)