Do ETFs make the market less efficient?

(MoneyWatch) I never cease to be amazed by what comes from the mouths of those who tout active management strategies. The people who make the statements are generally intelligent people, and they make what to the uneducated appear to be well-reasoned arguments. The only problem with their statements is that they are all-too-often wrong.

Lately, I've been hearing a lot about how exchange-traded funds (ETFs) are causing the market to be less efficient, when nothing could be further from the truth.

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ETFs, which are mostly index funds, have seen tremendous growth. They now have about $1.5 trillion of assets. You'll even hear acknowledgements from active managers that ETFs provide the express benefits of broad diversification, the ability to control your asset allocation, tax efficiency, and do so at low costs -- all worthy objectives. However, active managers also claim that:

• ETFs are making the market less efficient as they buy or sell stocks regardless of valuations. Thus, people willing to do intense research can uncover mispriced stocks.
• It's foolish to overdiversify and attempt to mimic indexes to achieve performance. Higher returns accrue to those who perform discriminating analysis.
• The only way to achieve superior long-term returns is to have the intellectual courage to differ from the mood of the day and the indexes to which we are compared.

And while that all may sound good to those who don't know better, the problem is that there's no evidence to support any of those claims. In fact, there's an overwhelming body of evidence to the contrary. For example, if ETFs were making the market less efficient, we should see evidence of that, and we don't. The Standard & Poor's Indices Versus Active scorecard shows us that every year. We haven't seen an increase in the percentage of active managers who are beating their appropriate benchmarks, nor in the persistence of winners. And this is true in all the asset classes.

There's probably no issue more widely studied in finance than the one of active versus passive investing as the winning strategy. The evidence is overwhelmingly on the side of a passive strategy. For example, professors Eugene Fama and Ken French studied the topic of performance persistence in their 2009 paper "Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates." They found that active managers as a group have not added any value over appropriate passive benchmarks. They concluded: "For (active) fund investors the simulation results are disheartening."

They did concede that the results look better when looking at gross returns -- the returns without the expense ratio included. However, gross returns are irrelevant to investors unless they can find an active manager willing to work for free.

Regarding concentration of stocks to improve returns, the 2008 study "Security Concentrations and Active Fund Management: Do Focused Funds Offer Superior Performance?" found that there was no evidence that focused funds outperform diversified funds. In fact, after controlling for other fund characteristics, funds with a large number of holdings significantly outperformed funds with a small number of holdings both before and after expenses. In other words, fund performance is positively, not negatively, correlated to the number of securities in the portfolio.

The bottom line is that:

• There's no evidence that ETFs have made the market less efficient. Active managers still persistently underperform across all asset classes.
• Even if there are too many ETFs as some claim, there's no evidence of active managers being able to persistently exploit any opportunities after costs.
• Concentrating your investments doesn't improve returns.

And finally, the idea that the road to superior performance is through active management confuses two issues -- beating the "market" or outperforming the vast majority of investors. Yes, it's true that the surest way to outperform an index is to not look like the index, concentrating your holdings in a few stocks you think are undervalued (mispriced). However, the evidence demonstrates that while it's possible to outperform, the much greater likelihood is that you will underperform. And the longer the horizon, the less likely outperformance becomes because the costs of the effort compound over time.

The other problem is confusing market returns with average returns. Active fund managers pitch their strategy this way: "If you index you will get average rates of return. You don't want to be average, do you? Don't you think you can do better than that? We can help you achieve that objective."

The mistake they want and need you to make is to fail to understand that by simply earning market returns, and having the discipline to adhere to your investment plan (asset allocation) you are virtually guaranteed to outperform the average investor, both institutional and individual.

Image courtesy of Flickr user 401(K) 2013