By LARRY SWEDROE
Nobel Prize winner Eugene Fama is considered the father of the efficient market hypothesis (EMH), which asserts that financial markets are “informationally efficient” — the result of financial markets processing millions of trades, reflecting the viewpoint of investors, worth hundreds of billions of dollars each day. Using these trades as inputs, the market functions as a powerful information-processing mechanism, aggregating vast amounts of dispersed information into prices, driving them toward the best estimate of the right price (fair value).
The EMH is a hypothesis (a model of how the world works), not a law (such as the law of gravity). In other words, it’s a simplification of the world that doesn’t always hold true. And like all models, by definition they are wrong (or they would be laws, like we have in the physical sciences). Fama himself recognised this. Writing in his first paper, he explained that “efficiency, like all perfect-competition supply-and-demand economics, is an ideal, which real-world markets can only approach. Empirical work can find only how close to or far from the ideal a given market is.” And Fama, with Kenneth French, wrote the 2005 paper Disagreement, Tastes, and Asset Prices, which showed how investor preferences for assets with “lottery-like” characteristics can lead to mispricings of assets from an economically rational perspective (explaining, for example, the anomaly that small growth stocks with high investment and low profitability have underperformed).
With that said, the EMH is a hypothesis that provides an important organising principle that helps us understand how markets function and prices are set. And most importantly, the evidence demonstrates that investors are best served by assuming the market is efficient. However, when there’s clear evidence of an inefficiency, it’s not prudent to ignore it just to hold to a stubborn belief in a pure form of the EMH. For example, faced with the overwhelming evidence on a momentum premium, Dimensional Fund Advisors (Fama led their research efforts and continues to play an important role at DFA) began incorporating momentum into its portfolios in 2003. In other words, even the investment firm most closely associated with Fama and his research doesn’t invest according to a strict, or one might say “religious” belief in the EMH. However, the historical evidence on efforts to generate alpha by exploiting market inefficiencies shows that markets behave much closer to the EMH than most investors believe and Wall Street and the financial media want and need them to believe.
The evidence
If markets are informationally efficient, we would expect that there would be no persistence of risk-adjusted outperformance by active managers beyond what would be randomly expected. In their June 2022 study The Fund Landscape, Dimensional analyzed the returns relative to its own self-declared benchmarks for U.S.-domiciled mutual funds and ETFs through 2021. As you review their findings, note that research has demonstrated that a significant number of funds understate their risks by failing to choose a benchmark that is the best fit. Instead, because the SEC allows for significant freedom in the choice of benchmarks, they choose one they are more likely to outperform. Thus, their risk-adjusted performance is overstated. Following is a summary of their findings for the 20-year period ending in 2021:
- Only 44 percent of the 2,813 equity funds that existed at the start of the period survived, and just 18 percent outperformed their self-declared benchmark.
- The percentage of equity funds that were top-quartile performers in consecutive five-year periods averaged just 21 percent. Randomly, we would expect 25 percent of top quartile performers to outperform—evidence that past performance is not a reliable predictor of future performance.
- Costs matter. The percentage of funds in the lowest quartile of expenses (average expense ratio of 84 basis points) that outperformed was 31 percent versus just 6 percent for funds in the highest quartile of expenses (1.75 percent average expense ratio).
- Turnover, resulting in trading costs such as brokerage fees, bid-ask spreads and market impact, can be just as large as a fund’s expense ratio, negatively impacting performance. The percentage of funds in the lowest quartile of expenses (average turnover of 27.5 percent) that outperformed was 32 percent versus just 9 percent for funds in the highest quartile of expenses (average turnover of 140.4 percent).
The results were very similar for the universe of bond funds. Dimensional’s findings are consistent with those of the annual SPIVA Persistence Scorecards, which regularly demonstrate that there is less persistence of outperformance than randomly expected. Thus, past performance is not a useful predictor. And unfortunately, efforts to find other useful predictors of future outperformance, such as active share, shared experiences and information ratio, have not demonstrated value (see here, here, here and here).
Investor takeaways
Active managers who attempt to outsmart the collective wisdom of the crowd are pitting their knowledge against the collective wisdom of all market participants. While we know that markets are not perfectly efficient, providing opportunities for active managers to exploit mispricings (anomalies), the evidence demonstrates that active management is a loser’s game. While it is possible to outperform, the odds of doing so are so poor it isn’t prudent to try. The result is that investors are far better off relying on market prices than searching for mispriced securities.
Unfortunately, despite the overwhelming body of evidence, many investors continue searching for winning funds and look to past performance as the main criterion for evaluating a manager’s future potential. The evidence also demonstrates that if you are going to ignore the evidence and use active managers, you should limit your choices to those with index fund-like expenses and turnover. While that still won’t put the odds in your favour, it will significantly improve them.
For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-22-363
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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