Investment Returns

Are Index Funds Destroying Market Efficiency?

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Investment Returns

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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


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