When I tell people that I use index funds and ETFs to build my clients’ portfolios, they seem a bit surprised that I would consider markets to be efficient. Many of my friends and most of my professional contacts are in the business of managing portfolios actively — whether at mutual funds, hedge funds, or other asset managers. They would expect me to follow a similar approach, rather than “settling for average” by using index funds and ETFs. But there’s a subtle difference between accepting that markets are efficient and using index funds and ETFs over actively managed products like mutual funds.
Efficient Market Hypothesis
Morningstar defines the Efficient Market Hypothesis (EMH) as:
A market theory that evolved from a 1960’s Ph.D. dissertation by Eugene Fama [a recent Nobel Prize winner], the efficient market hypothesis (EMH) states that at any given time and in a liquid market, [stock] prices fully reflect all available information […] This theory contends that since markets are efficient and current prices reflect all information, attempts to outperform the market are essentially a game of chance rather than one of skill.
Do I accept this? That it is impossible to beat the market average by picking stocks? No, of course not. Even in a market as efficient and liquid as US stocks, there is room to do better than the market average.
However, I do accept and respect the reality that beating the market consistently after fees is extremely hard to do. And it’s even harder to identify a portfolio manager that can, before they do so. A study I like to quote estimates that less than 1% of mutual fund managers have enough stock-picking skill to beat their fees. But before fees, roughly 10% of fund managers showed stock-picking skill — an estimate that is not zero, as efficient markets would imply.
So no, the markets are not efficient. But it is a pretty good approximation for most investors. I consider physics a good analogy. When you first learn physics, you assume that friction is zero, drag is zero, and mass is concentrated at a single point. As you progress, you start relaxing those assumptions. Assuming an efficient market serves a similar purpose for investing.
Someone who believes in efficient markets would naturally follow an investment strategy that I call Basic Strategy. However, even investors who don’t believe in efficient markets, but do accept that beating the market is extremely difficult, should follow a form of Basic Strategy. And that’s what I do. I start with Basic Strategy, then add wrinkles as I see the evidence to support them.
How to Beat the Stock Market
Academic literature and industry research reveal a long list of stock attributes that predict higher performance, typically called factors. Academics who don’t want to let go of efficient markets interpret these factors as risks that investors are getting paid to take. Others, like me, simply view these as a list of how the markets are not quite efficient. These are the frictions and drags of investing. Here are a few popular ones:
Value. Whether you use P/B , P/E, or any other value metric, the evidence is strong that stocks that are cheap perform better than those that are expensive over a long enough period of time — typically years.
Size. Smaller companies perform better than large ones. The evidence is there, but it’s not as unanimous as value. Notice that these first two factors form the basis for Morningstar’s style box.
Momentum. Stocks that have risen in the recent past continue to do so, and vice versa. The evidence for this is quite strong and is fairly consistent across a variety of markets. Since this works best in the short term, the tax and transaction costs of following this strategy are high.
Profitability/Quality. Companies that have been profitable perform better than ones that haven’t been. Although the evidence wouldn’t be widely accepted until later, this is the factor that Warren Buffett made famous with, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Would the best way to take advantage of these factors be to pick and buy 5, 10, or 25 stocks that best exhibit these attributes? For most investors, no. The more effective and prudent approach would be to invest in diversified funds that let you capture these effects at a low cost — funds like value and small cap index funds, which are broadly available for both US and foreign stock markets. Even the latter factors can be captured in newer funds and ETFs.
Factors for Asset Classes
Why stop at factors for stocks? How about factors at the asset class level that help us choose between US stocks, foreign stocks, US bonds, etc? If you’ve read my previous articles, you already know that I use these two factors to identify attractive asset classes:
Value. Asset classes that are cheap perform better than those that are expensive over a long enough period of time — typically years.
Momentum. Asset classes that have risen in the recent past continue to do so, and vice versa. This works best in the short term.
These two factors are just a subset of the longer list above. What works at the micro level (individual stocks) also seems to work at the macro level (asset classes). I focus on these two factors to keep my analysis simple while being applicable and consistent across a wide range of asset classes.
Do I think the markets are efficient? No. I think the evidence is pretty clear that the markets are not perfectly efficient. But my use of index funds and ETFs is primarily based on the disappointing track record of traditional mutual funds, not because of market efficiency. The risk of mutual funds underperforming after fees and taxes seem to be far greater than their chance of beating the market average.
I rely on factors like the ones listed above to improve on Basic Strategy. Of course, these factors don’t work every time. Investing is unfortunately not that easy. There have been, and will be, years where they perform worse than the market average — making discipline a requirement to profit from these effects. To mitigate this risk, you can use these factors as an enhancement to Basic Strategy, rather than as a complete substitute.