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Why Index Investors Shouldn't Care Whether Markets are Efficient

More than thirty years after the launch of the first index fund, one of investing's most stubborn canards remains: The success of index funds is somehow related to how efficient or inefficient the stock market is.

Nothing could be further from the truth.

The "efficient markets hypothesis" (EMH) was developed by Eugene Fama in the 1960s. Essentially, it says that stock prices reflect all current information, and react quickly to new information. In other words, EMH advocates believe that there's nothing that you know about Wal-Mart, for instance, that isn't already reflected in the stock's current price. If that is true, attempting to outperform the market index is essentially a mug's game, because no amount of research or analysis can provide you with an edge over your fellow investors.

Because the EMH gained notoriety around the same time that index funds first became available, and because EMH's proponents (unsurprisingly) recommend the use of index funds, indexing and the EMH have been conflated over the years; a belief in one is thought to require a belief in the other.

As proof, we need look no further than the recent contributions Legg Mason's Robert Hagstrom has made to MoneyWatch, where, in defense of active management, he trots out his skepticism about the stock market's efficiency.

But as MoneyWatch's Larry Swedroe and Forbes's Rick Ferri have both touched upon, indexing's success is not predicated on market efficiency; rather, the logic of index investing rests solely on a minimization of expenses.

To illustrate this, let's consider two different sectors of the overall stock market, one of which is highly efficient and one which is very inefficient.

An efficient market will have winners and losers, of course, but their margins relative to the market index will be rather small. Likewise, an inefficient market will have both winners and losers. The only difference is that the spread of their relative performance will be much greater. While the vast majority of investors might be within one percent of the market index in an efficient market, that spread could be three percent or more in an inefficient market.

But regardless of the margin of victory or loss, there is no denying the fundamental mathematics of investing that Nobel Laureate William Sharpe explained so well: investors as a group will earn the market's return before costs, and will lag the market's return after costs. This is true for both the stock market over all, and the discrete sectors that it's composed of.

So while there will be bigger winners and bigger losers in an inefficient market, an investor in such a market who minimizes their expenses will, by definition, earn returns that outpace the returns earned by the majority of their counterparts. The math is simple, the logic inescapable.

A quick glance at the Standard & Poor's active versus passive scorecards confirms this fact. In the most recent report, we see that 60 percent of all actively managed large-cap funds trailed their benchmark over the past five years. In the presumably less-efficient small-cap sector, 67 percent of actively managed funds were outperformed. Likewise, 89 percent of both international funds and emerging market funds (two additional sectors that are thought to be inefficient) trailed their benchmarks over the past five years.

If active managers as a group are adding value in these inefficient market sectors, I'm unable to find evidence of it.

Mutual fund managers, of course, have a vested interest in trying to muddy the waters by making investors believe that the success of indexing is predicated on just how accurate a much-debated academic theory is. But fear not, for indexing's success relies not a whit on how efficient or inefficient the stock markets are; index funds work for one simple and inexorable reason -- the less you pay, the more you keep.

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