The Royal Swedish Academy of Sciences, in honoring Eugene F. Fama this year as a co-winner of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, recognized the triumph of the efficient market hypothesis, which through index funds has improved the investment outcomes of pension funds and other large asset pools as well as portfolios of 401(k) participants.
The recognition was long overdue, even though the hypothesis has long been challenged because of the volatility of assets prices and of markets.
Indeed, the Nobel committee at the same time honored as a co-winner Robert J. Shiller, Sterling professor of economics at Yale University who is a pioneer in the study of behavioral finance. The award to Mr. Shiller — whose behavioral finance theories are often at odds with the efficient market hypothesis — drew attention to another field also worthy of recognition. Mr. Shiller's work, which combines psychological insights with economics and finance, contends that asset prices are too volatile to be reconciled by the standard assumptions of rationality and efficiency of modern portfolio theory, according to the academy in awarding the prize.
The financial crisis of 2008 gave a new boost to the challenges to market efficiency and the notion that investors would generally find that active management would prevail over the returns of passively managed market index funds. The deep plunge in market prices during the crisis was seen as exposing flaws in market efficiency as well as exposing investors to big losses.
The efficient market hypothesis contends that the pricing of stocks and bonds is efficient, reflecting all known information, so active investment strategies cannot gain an advantage over the long term. This idea led to the development of index fund investing. Because of their nature, capitalization-weighted index funds have come under criticism for appearing to lead investors to excessive valuations that can contribute to market crisis.
Indeed, in 2007, as the financial crisis began to percolate, 54% of active large-cap core domestic managers outperformed the Standard & Poor's 500 index, an indication they correctly forecast a coming downturn. As a result, most active managers outperformed their appropriate indexes including in core, growth and value styles.
In 2008, 78% of active large-cap value domestic managers outperformed the S&P 500 value index. A reason is “many active managers moved into cash as the market was tanking,” Aye M. Soe, S&P director, global research and design, said in an interview. “So they outperformed the market,” or index funds, which continuously holds the stock components and cannot move into cash.
At a news conference Oct. 14 following the Nobel announcement, Mr. Fama, the Robert R. McCormick distinguished service professor of finance at the University of Chicago Booth School of Business, refuted the challenge from the financial crisis to the concept of market efficiency.
“The world is a very uncertain place, and you expect that (would) be reflected in asset prices,” Mr. Fama said. “You expect to see a lot of volatility in asset prices. One criticism of the efficient market during the 2008 (crisis) period was that volatility was very high. But volatility is always very high in bad times. That is precisely what you'd expect in an efficient market. I thought that (financial crisis) was a great experiment and it validated what we were talking about.”
As the market recovered, index funds prevailed across the asset sizes and styles over active managers generally, according to S&P data.
Even with the emergence of behavioral finance and the finding of some anomalies in the market, the concept of efficiency still is strong. Even Mr. Fama recognizes persistence in anomalies in returns, especially in small and value stocks, but they are hard to identify consistently.
“Conventional wisdom says where there appears to be less of an efficient market, such as in small-cap stocks, it is better to go active,” to improve outperformance, rather than index, said Ms. Soe. “But we don't find that the case” based on S&P's comparison of active management and indexes. “Active manages aren't winning in small cap.”
Exploiting anomalies is a challenge because active managers have to overcome the higher expenses of investment management fees and transactions and other costs compared with the lower costs of index funds.
Some managers clearly outperform, but few do so consistently. Trying to discover which ones can do so is difficult, even with the help of consultants. Indeed, new research from the Saïd Business School at Oxford University, released in August and September, found that investment consulting firms generally add no value in recommending U.S. equity managers.
The Nobel academy recognized that investors already know the value of index funds. As the academy stated in its announcement, index funds in 2012 “had over $3.6 trillion under management and accounted for 41% of the worldwide flows into mutual funds.”
The efficient market hypothesis has contributed to improving the performance of investors, even as Mr. Fama, with his factor models, acknowledges that there are pockets of market inefficiency that might be exploited. n
This article originally appeared in the October 28, 2013 print issue as, "Market efficiency's challenge".