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Why indexing matters

The efficient market hypothesis

You’re probably already familiar with the efficient market hypothesis (or EMH), which argues that a security’s price on the open market inherently reflects all available information or market influences and is appraised accordingly. That is to say: Pricing works.

Although fair pricing is the basic concept of the financial markets, the EMH isn’t without controversy. That’s because it implies that it’s impossible to beat the market by buying undervalued securities or selling overvalued ones, since by definition no such things would exist; there are only prices, which are always and inherently fairly priced. Therefore, to a true adherent of efficient market hypothesis, the best one can hope to do is capture the market’s returns—such as by buying products based on indexes.

What’s the difference between passive and active?

Passive investing is the EMH-compliant strategy, a “set-it-and-forget-it” school of investing in which you allocate financial resources in an attempt to reflect the market without any reliance on market predictions or forecasts. This is most often achieved via index-tracking investing—that is, by holding all the securities (or a fund that holds all the securities) in that index in the same proportions as the index weightings.

Passive investing assumes perfect market efficiency. In reality, however, markets are not perfectly efficient. Temporary pricing and valuation inconsistencies do arise, providing pockets of opportunity for those investors alert to their presence.

Active investing looks to exploit these inefficiencies by snatching up undervalued securities and selling off overvalued ones, with the aim of outperforming the baseline market. It’s a “pick-and-choose” strategy, where managers select individual stocks or funds and which weights they should be held in. Generally performance is gauged against some benchmark market index.

Note that indexes are equally critical to both types of investors—it’s just that passive investors want to replicate an index’s performance, while active investors hope to beat it.

Passive and active: not an either-or

Much debate surrounds the relative merits and efficacy of active or passive investing, but it’s not so much a question of who’s right as when they’re right. Research shows that while active investing can produce outsized returns in the short term, these returns are difficult to sustain over longer investment horizons. In fact, the longer the time horizon, the worse active investment tends to fare: Over a ten year period, for example, 80% of active managers fail to even match their benchmarks, much less beat them.

Another downside of active investing is that it tends to cost more than passive methods, due to higher turnover rate and increased commission or brokerage fees. The higher incidence of taxable events also tends to increase active investing costs. The average actively managed stock mutual fund, for example, costs between 1.31-1.57% per year, compared to the average passively-managed equity ETF, which costs between 0.47-0.56%.  Over time, these higher expenses will eat into the returns of an active portfolio, even if outperformance is consistently achieved.

In practice, most advisors use a blend of both active and passive strategies to provide returns for their clients. New index types, such as fundamental indexes, attempt to make this easier by introducing alternative measures and weighting systems, some of which characteristics might have been used traditionally by active managers.  

 

The Pros and Cons of Passive vs. Active

 

Active

Passive

Pros

* Can offer outperformance in short term

* If properly implemented, can exploit positive market moves and mitigate effect of adverse market moves

* Offers higher returns over long investment horizons

* Less expensive in the long-term

Cons

* More expensive in the long-term

* Does not outperform long-term

* Cannot avoid broad market downturns or outperform market upswings

* Can’t offer outperformance of the market