Investment Returns

Are Index Funds Destroying Market Efficiency?

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

Q1 hedge fund letters, conference, scoops etc

Investment Returns

Tumisu / Pixabay

This article originally appeared on ETF.COM here.

Over the past few decades, there has been a substantial shift from active to passive investment strategies. This shift has occurred as investors have become more aware of the persistent failure of active management, as demonstrated in the S&P Dow Jones biannual Indices Versus Active (SPIVA) reports.

A January 2019 Federal Reserve Bank of Boston study, “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?”, found that “Passive funds made up 45% of the assets under management (AUM) in equity funds and 26% for bond funds at the end of 2017, whereas both shares were less than 5% in 2005.”

Wall Street has been attacking and ridiculing passive investing for decades. Among the arguments are that the rise of passive investing results in a reduction in price discovery efforts, leading to prices being distorted and capital allocated inefficiently. This occurs because indexing either has too large an influence on prices or it inhibits price discovery because it lowers aggregate market trading volume.

The great irony is that if indexing’s popularity were distorting prices, active managers should be cheering, not ranting against its use, as it would provide them easy pickings, allowing them to outperform. (Note that if money flowing into passive funds distorts prices, it could still make it difficult for active managers while it is occurring, as distortions could persist as long as the flow continued. Eventually, though, the opportunity would manifest itself.) In reality, the rise of indexing has coincided with a dramatic fall in the percentage of active managers outperforming on a risk-adjusted basis.

Evidence

As evidence of the declining ability of active management to deliver alpha, the study “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, which appeared in the Summer 2014 issue of The Journal of Portfolio Management, found that the percentage of skilled managers was about 20% in 1993. By 2011, it had fallen to just 1.6%.

This closely matches the result of the 2010 paper “Luck versus Skill in the Cross-Section of Mutual Fund Returns.” The authors, Eugene Fama and Kenneth French, found that only managers in the 98th and 99th percentiles showed evidence of statistically significant skill. On an after-tax basis, that 2% would be even lower.

Vanguard’s research team contributed to the debate on the negative impact of passive investing on the price discovery function with its March 2019 study “A Drop in the Bucket: Indexing’s Share of U.S. Trading Activity.” To test the impact of indexing on price discovery, Vanguard measured not only turnover but cash-flow-induced trading.

Read the full article here by Larry Swedroe, Advisor Perspectives


Saved Articles
X
TextTExtLInkTextTExtLInk

The Life and Career of Charlie Munger

Charlie is more than just Warren Buffett’s friend and Berkshire Hathaway’s Vice Chairman – Buffett has actually credited him with redefining how he looks at investing. Now you can learn from Charlie firsthand via this incredible ebook and over a dozen other famous investor studies by signing up below:

  • Learn from the best and forever change your investing perspective
  • One incredible tidbit of knowledge after another in the page-turning masterpiece of a book
  • Discover the secrets to Charlie’s success and how to apply it to your investing
Never Miss A Story!
Subscribe to ValueWalk Newsletter. We respect your privacy.

Congrats! Are you a smart person?

We have an exclusive targeted & limited time offer for being a sophisticated and loyal reader.

ValueWalkPremium is a website and newsletter on the latest industry news much of which is not in the public domain and obtained via our sources.

We also have 10 years of resources on how to use this information to better your investment process.

Sign up for  today and get our exclusive content for 40% off. This is our second biggest discount ever!!

Use coupon code VIP20 or click on the button below

Limited time offer only ENDS 2/29/2019 or after next 25 subscribers take advantage whichever comes first – please do not share this discount with others

 

0