Why index funds out perform active funds

Why index funds outperform active funds

The efficient market hypothesis originated from an empirical observation on the activity within the stock market, in particular the consistency of individual stocks out performing active managers.

This observation documented the obvious data points on the price movement of these stocks’ vs active managers. Hence why in 1965, everything changed within financial securities market and not just for Eugene Fama.

Investors were instilled with a new sense of confidence having been told by their accountants, financial advisors, friends, family, colleagues and radio that they could have success in the stock market because the efficiency of a particular firms pricing is not necessarily determined on the basis of a company’s fundamental indictors but on the assumption that:

Because all market participants have the same access to the same information, the prediction of price movement is not a necessary exercise. Instead, investors should diversify their investments, taking advantage of market anomalies (anomalies in price movement are often attributed to legal, political and economic risks).

It is on this basis that any investor who diversifies their portfolio and makes purchases in stocks with the intention of long-term investment would outperform active managers.

What about the capital asset pricing model contradiction?

The expectation of anomalies within the EPH is consistent with prediction of price movement with stocks identified as “under-valued” in activities known as value investing.

An example of value investing would be identifying stocks within the ASX 200 and ASX 300. These stocks would then be subject to fundamental analysis and using the relative valuation models which is done by comparing the profit to equity ratio of companies within the same sector to ascertain the perceived value of the company vs the “actual value”.

Absolute valuation is an analysis based of the fundamental indicator of that particular stock and comparing companies with similar activities.

The obvious criticism of value investing is that because every stock is different many, its not possible to have success by following the same strategy for analysis when attempting to make a prediction.

The partial defense to this criticism is that because it has been identified as undervalued the question changes from “if there is a price movement” to “when there will be a price movement”, this question then becomes further scrutinized through volatility analysis, which makes semi-accurate prediction within the immediate short-term but is not as useful in the long term.

But as always, “No guarantees”.