The "Mythbuster" approach to Indexing : Inefficient Markets

Probably the most common myth I hear, and I hear it a lot, is, “We’re happy to index large-cap U.S. stocks, but we prefer active in small-cap or international markets.” Makes sense, right? After all, large-cap stocks, those in the S&P 500 Index, for example, are closely followed by analysts, traders, portfolio managers, and sell-side research firms.

MythBusters is one of those cable shows that I find myself gravitating toward whenever I’m channel surfing. It’s just one of those shows that I find wildly entertaining. I know, I know . . . nerd alert! But that’s what you get when you ask an investment guy to “show a bit of personality.” In any event, for those who are less familiar, each episode follows a similar structure:

A common myth is presented and then the hosts apply scientific method and experiments to test its validity. Watching an episode recently got me thinking about certain investing myths that never seem to die. In particular, there are a number of myths surrounding indexing that could really benefit from the debunking process. So I decided to dedicate a series of blogs to tackling these indexing myths and hopefully set the record straight.

Probably the most common myth I hear, and I hear it a lot, is, “We’re happy to index large-cap U.S. stocks, but we prefer active in small-cap or international markets.” Makes sense, right? After all, large-cap stocks, those in the S&P 500 Index, for example, are closely followed by analysts, traders, portfolio managers, and sell-side research firms. All that coverage should make large-cap U.S. stocks highly efficient and, therefore, difficult to beat.

On the other hand, such coverage is much less likely for a small-cap emerging markets firm. Analysts who are able to “discover” that particular stock have the potential to add a winner to their actively managed portfolios. As a result, we have the industrywide proclivity to invest in active managers in these so-called inefficient market segments. Of course, Vanguard does believe in the potential for low-cost, talented active management to add value—that’s not the issue at hand—it’s the view that one should consider active in certain markets because they are thought to be inefficient.

While we can perform many different tests, really the only one we need also happens to be the easiest—the sophisticated exercise also known as the eyeball test! If these markets were less efficient, we’d see a large portion—dare I say majority—of active funds outperforming not just their own benchmark, but also low-cost passive alternatives. However, in recently updated research on indexing, Vanguard found that once ”dead funds” (i.e., funds that were merged or liquidated) were included, 84% of actively managed small-cap U.S. funds, 73% of non-U.S. developed markets fund and 71% of emerging markets funds underperformed the average return of low-cost index funds in those same categories over the ten years ended 2013 (see figure 1. below).

By my count, that’s three out of every four funds that failed to deliver on the theory that these markets are less efficient and therefore ripe for outperformance. Compare that to large-cap U.S. stocks, where 85% of funds underperformed.

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