Are Markets Still Efficient (Vis a Vis Individual Equity Valuations) If Everyone Is An Index Fund Investor?

From the WSJ, the dying business of picking stocks.

Pension funds, endowments, 401(k) retirement plans and retail investors are flooding into passive investment funds, which run on autopilot by tracking an index. Stock pickers, archetypes of 20th century Wall Street, are being pushed to the margins.

Over the three years ended Aug. 31, investors added nearly $1.3 trillion to passive mutual funds and their brethren—passive exchange-traded funds—while draining more than a quarter trillion from active funds, according to Morningstar Inc.

Advocates of passive funds have long cited their superior performance over time, lower fees and simplicity. Today, that credo has been effectively institutionalized, with government regulators, plaintiffs' lawyers and performance data pushing investors away from active stock picking.

  • http://www.vaslaw.com/ Richard Arrett

    Very good question.

    I am just a regular investor and not a professional.

    However, I do own index EFT's and index mutual funds and do still buy and sell occasionally.

    Mostly to time the market (which I know I am not supposed to do - but still do).

    So my theory is that people (and institutions) will still buy and sell based on the business cycle.

    The PE of the S&P 500 is about 22 - which is pretty high - so some people, who think the market is due for a correction may sell and buy back when the PE ratio is 15 (or pick your number).

    Just a personal theory, based on nothing buy gut feel.

    What do you think?

  • kevinsdick

    Like any other thick market, arbitrage opportunities will still squeeze the market towards efficiency. It may only take 0.1% or 0.01% of the investors to actively trade because those will be the ones with the most comparative advantage in spotting mispricings. It's been a while since grad school, but IIRC there was a fairly deep literature on this.

  • craftman

    This was my line of thinking. Before market information was so readily available to everyone, you might need 1,000,000 individuals monitoring markets to trade on key pieces of data. Now you may be able to get away with 50,000-100,000.

  • Shane

    I invest personally and I time the market.

    On long period moves, market timing is very simple, and in the market close enough really is good enough. ETFs are IMO for things like gold, S&P and the like. I don't like the basket of stocks theory I find it to be a hedge against real work. Also in an ETF someone is kicking out the "losers" and buying the "winners", this in my mind is tantamount to a mutual fund doing the work for you albeit with lower fees. Really an active manager is a cop-out feel good move. If you want to use an actively managed instrument (if you can find a good one) to help diversify then you should otherwise be wary of them they for the most part are run by charlatans and should be avoided.

    Everyone has an investing style and that should be honed and cultivated through introspection and most importantly the pain of loss. Hone your style and you will make money follow someone else and you will lose.

    My two cents.

  • Shane

    ETF's create market inefficiency not solve it. Funds will weight their portfolios based on ... whatever. The criteria that they use is subject to their own biases known to them or not. This attempt to homogenize will create winners and losers in individual stocks. If you can chose the stocks that have been thrown in the dustbin because the ETF (or whomever) thinks they are not good then if you have superior understanding you will profit.

    Nothing has changed. This is just another wave of market madness with a different name and a different flavor. Those that understand this will do fine those that think things are "different" now will be on the wrong side of the trade (like they always are).

  • morganovich

    any time you allocate assets for reasons other than the fundamentals of the underlying companies, you make the market less efficient. doing so make the economy grow at a lower rate. this, in turn, ultimately depresses returns to equities.

    so, it's quite possible that in a market with all active investors, most would underperform the market, but, that the performance of the index if, say, 40% of people indexed.

    market return is not an exogenous variable. it's a function of the investment strategies used.

    would you rather get 7% in a market doing 8% and have a stronger economy (that would likely show up in income, innovation etc or get 5% in a market doing 5%?

  • Fred_Z

    I look forward to the lads finding new and excellent ways to game this investing strategy.

    Because they will.

  • Michael Stack

    I like to think of passive investing strategies like these as working, precisely because a lot of people don't think they do. Voting is the opposite - it is a waste of time, precisely because people believe it is so valuable.

  • Dan Wendlick

    There are two ways to win consistently in the market: you can know more or move faster. As an individual investor, you're simply not going to have the connections or clout to get the kind of information that large companies share with their banks and large investment houses, at least not soon enough to act before the information deficit has been arbitraged by someone else. You're simply not going to outplay the guy having lunch with the board of directors, or the 22-year-old rocket scientists running simulations of the Chinese semiconductor industry and how that will literally affect the price of rice three years from now.
    Given high-frequency momentum trading on the millisecond level, any technical changes are going to arbed out before a human can even notice them. So barring privileged access to insider information, you're best bet is to bet on the market as a whole, rather than on individual issues, hence buy-and-hold and index funds.

  • marque2

    It makes my personal investing more efficient though. I don't have the finances/buying power of JP Morgan, and I don't have the time to be a stock picker, so I make my personal finances most efficient by purchasing reasonable investments at as low a cost as personally possible, by purchasing low maintenance funds.
    Once costs go up beyond micro-pennies per trade, that the investment bankers can command, I am, as an individual losing money. Maybe a large pension fund or university can beat the market, but looking at them, they seem to be doing worse than the market as well, and have higher costs. Also, at my level, having maybe 100 grand to invest, I certainly won't be getting a hedge fund expert to manage my affairs, and the "expert" I do get will take about 1% more per year off the top of my funds, in addition to account fees, and mutual fund management fees.

    Where getting a financial advisor/broker helps is if you have tons of money, have enough issues where you need to game the tax system, and need help planning cash inflows and outflows. As a small time plugger, I don't have any of these issues, so it isn't worth paying extra.

  • marque2

    By the way, if you ever do get a broker's license, part of your training is that all the common methods people live by to game the market have pretty much been falsified, Dow Theory, head and shoulders, pick losers (they will pop most), trend line analysis ... all don't work. But your first day after you get back to the office, some broker will tell you about a great stock pick because he/she sees a reverse head and shoulders. It is pretty crazy.

    Wall street makes its money off arbitrage, charging a tad more to sell someone a stock than to acquire it for them as a transaction fee.

  • Tanuki Man

    Anything that disintermediates stock brokers out of the equation is fine by me.

  • Juker

    I'm definitely an amateur but have been trading nearly full time for 15
    years. I'm not an investor. While the markets are "efficient", I do
    not believe in the efficient market hypothesis in as much as that means a
    random walk.

    I refer you to Mandelbrot's book, "The
    miss-behavior of markets". Long term the markets are far from a normal
    distribution. More like a Levy distribution, with big fat tails.

    Having said that, there is little you can do without using a normal distribution.

    I
    have advanced to where I ONLY SELL OPTIONS. My trading now is
    probability based. And based, unfortunately, on the normal
    distribution. How to get around the fat tails? Trade very small and trade very often. That's the best you can do.

  • Signal

    In theory, if everyone is an index investor, they really aren't -- because there's nothing to index to.

    In reality, however, there just need to be enough investors to produce price signals. A market exists so long as there are willing buyers and sellers. An index exists if those buyers and sellers act and move the price.

    I don't see much of a problem with indexes moving from 20% of the market to 75% -- so long as there are willing buyers and sellers doing trades. As the percentage of B&S increases, we'll likely see volatility -- and a reduction in index investors. Indexing will limit itself, just like our climate will.

  • Herb
  • Heresiarch

    Markets aren't efficient in the first place. The most common illustration seems to be prices just before and after the crash on Black Monday in 1987, though I suppose it could really be true about any crash. But the logic is solid either way. No new information about stocks or any macroeconomic factor had come to light that day that could have rationalized the 20% fall in stock prices. So the market had to have been irrational at least one of those two times.