Published: Feb. 20, 2024 at 11:54 a.m. ET
No, the stock market hasn’t become easier to beat.
That’s important to keep in mind as a counter to the argument that, because index funds have “officially won” the battle to manage more money than actively managed funds, the stock market has become less efficient and therefore easier to beat. While this is a convenient narrative that active managers can use to justify their high fees, it simply isn’t true.
The…
No, the stock market hasn’t become easier to beat.
That’s important to keep in mind as a counter to the argument that, because index funds have “officially won” the battle to manage more money than actively managed funds, the stock market has become less efficient and therefore easier to beat. While this is a convenient narrative that active managers can use to justify their high fees, it simply isn’t true.
The victory that index funds have won was announced earlier this month by John Rekenthaler, vice president, research for Morningstar Research Services, a subsidiary of Morningstar. According to his calculations, taking both open-end mutual funds and exchange-traded funds into account, in January “for the first time, passively managed funds controlled more assets than did their actively managed competitors.”
The argument that the growth of indexing makes the market less efficient makes sense. Index funds own stocks in proportion to their relative market caps rather than according to their relative current and future profitability. So it’s entirely plausible that the growth of indexing will lead to some stocks being overvalued while others will be undervalued.
But “the existence of inefficiency does not mean that the average active manager can beat the market,” according to Lawrence Tint. Tint is the former U.S. chief executive of Barclays Global Investors, the organization that created iShares (now part of BlackRock
BLK
).
In an interview, Tint explained that by definition, the combined portfolio of all active investors will be identical to the combined portfolio of all index funds. Therefore, before transaction costs the average active investor will equal the market. But after transaction costs, active investors on average will lag behind. “No matter how inefficient” the market has become, he said, this conclusion “is still true.”
For a fuller discussion of this argument, Tint referred to an influential article from more than 30 years ago by Nobel laureate William Sharpe, titled “The Arithmetic of Active Management.” (At the time of that article, Tint and Sharpe together ran an investment consulting firm.) Sharpe wrote that “after costs, the return on the average actively managed dollar will be less than the return” of the overall market, and that this conclusion depends “only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”
So run, don’t walk, away from fund managers and advisers who argue that the growth of index funds means you should want active management more than ever. The case in favor of indexation was overwhelming 50 years ago, before the first index was even created, and remains just as compelling today.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].
