Markets

Can You Exploit the "Inefficient" Indian Market?

By Larry Swedroe

Updated on: July 26, 2010 / 10:32 AM EDT / MoneyWatch

One of the more persistent myths about active investing is that it may not work in efficient markets such as U.S. large-cap stocks, but still adds value in less efficient markets such as emerging markets. Let's look at India to see if this is true.

In his paper "The Arithmetic of Active Management," Nobel Prize winner William Sharpe demonstrated that: "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."

Still, we continue to hear claims that markets such as India are inefficient and that Indian fund managers have information not available to the rest of the market. If true, this means Indian fund managers will be able to add value.

Thanks to the article "Myths About India" in the July/August 2010 edition of the Journal of Indexes, we can refute such claims. The author studied the performance of actively managed Indian mutual funds for the six calendar years ending in 2009. The following is a summary of the findings.

About 60 percent of the funds underperformed the Nifty BeES Index.
Past performance wasn't predictive of future performance as persistence of outperformance was less than randomly expected.

The author also noted that it's only likely to get more difficult to beat the market because the Indian market is becoming increasingly dominated by professional managers (leaving fewer and fewer "victims" to exploit). In addition, assets under management are growing, leading to increased hurdles in the effort to add alpha. (For more on this, see Jonathan Berk's excellent paper "The Five Myths of Active Investing.")

Believers in active management need you to cling to myths because that is the way they are most likely to achieve their financial goals. Of course, helping them achieve their goals is not your problem. The bottom line is that passive investing is the winner's game, whether you are playing in New York or Mumbai.