My recent Three Things post on market efficiency caused quite a stir in my email inbox. For instance, someone writes in:
“Fama and the EMHers are being proven right by the financial markets. As the latest SPIVA report showed, active managers cannot beat the market consistently. This proves that the market is more efficient than anyone who tries to actively intervene.”
This is a commonly cited “fact” in research articles and on the internet. But it is completely false. The performance of active managers neither proves nor disproves anything about market “efficiency”.
Let’s start with the most basic facts. The arithmetic of the market shows us that the aggregate of all outstanding financial assets will generate some total return. The holders of these financial assets will earn this total return MINUS taxes, fees and other frictions. The more “active” you are the more frictions you incur. Therefore, in the aggregate, more active investors MUST underperform the market over long enough time periods. This doesn’t say anything about their aggregate skill. It is simply math. More importantly, we all underperform an index after taxes and fees because an index generates a frictionless return. Thing is, high tax and high fee investors underperform by MORE in the aggregate.
This can be further enforced by assessing the performance of “passive” indexers. In this piece last year I showed that passive indexers regularly underperform the Global Financial Asset Portfolio. They are no better at compiling their own allocation of index funds than a much broader index. More importantly, this showed that the entire idea of “passive indexing” is often misleading and implies that we aren’t all engaged in some form of asset picking when we very clearly are. It just so happens that some asset allocators pick their assets in a tax and fee efficient form while others don’t.
Further, an “index” is nothing more than a human construct. Every index we use is a compilation of some human picked set of financial assets. There is no such thing as an index that represents the entire “market” of outstanding financial assets. Even popular indexes like the S&P 500 are actively picked by a committee and represent a fairly small amount of the world’s total financial assets (roughly 15%). So, while you might not like being an “active” investor, you are indeed engaging in a form of active investing by owning something like the S&P 500 index. It just so happens to be a much smarter and more efficient way of owning assets than say, a high churn and high fee fund like most mutual funds.
It’s true that high fee and highly active asset managers are often bad for your wealth. This is not even a controversial point. But the poor performance of these high fee and high tax managers does not prove anything about how “efficient” the market is. It just proves that arithmetic works.