The efficient market hypothesis and active investing
13 November 2017 | Portfolio construction
Commentary by Ankul Daga, senior investment strategist for Vanguard Asset Management.
Some advisers take a view on market efficiency when deciding whether to go active or passive. Often that translates into going passive in efficient markets, like US equities, and active in markets considered less efficient, such as emerging markets. On the face of it, this seems to make sense. But are active managers any more successful in these so-called inefficient markets?
Let's first consider what we mean by the very technical-sounding efficient market hypothesis. This hypothesis claims that market prices reflect all available relevant information at any time. Share prices will then always accurately reflect their value, making any technical or fundamental analysis redundant. Essentially, it's impossible to beat the market.
But are markets truly efficient? Market efficiency can be described as weak or strong with varying degrees in between. The US market is thought of as the most efficient market, with plenty of buyers and sellers acting on different signals and using multiple sources of free-flowing information. Emerging markets, on the other hand, are considered less efficient. These markets may not be as liquid, perhaps there are fewer participants, and it's more difficult to access information and maybe even more costly and burdensome to trade in them. This kind of market may present more opportunities for investors to find some sort of edge or informational advantage than, say, the US stock market.
If you follow that logic, you can understand why some advisers choose passive in US equities and active in emerging markets. But let's look at the data.
While luck can play a big role in a given year, you would expect active managers to struggle in efficient markets over a 10-year horizon. And, as our analysis shows, 91% underperform their benchmarks in US equities. But our analysis shows that 84% of emerging markets active managers also underperform. This is a high number if you perceive emerging markets to be inefficient.
Active managers are relatively more successful in Europe. Based on the efficiency hypothesis, does thart make the UK and other European markets less efficient than emerging markets? And yet looking at the chart, we see that 31% and 33% of active managers of UK and euro zone equities, respectively, outperformed. Only 16% managed the same feat in emerging markets.
The point I want to make is that views on market efficiency are a poor way to decide whether to use an active or passive strategy. Even if you're comfortable making a judgement on the efficiency of markets, this view may not translate into investing success.
The percentage of underperforming actively managed funds (using prospectus benchmark) over 10 years
Past performance is not a reliable indicator of future results.
Sources: Vanguard calculations, using data from Morningstar, Inc.
Notes: Fund universe includes funds available for sale in the UK, filtered according to the description above, from the following Morningstar categories: UK equity – flex cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Europe equity – Europe OE: flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Euro zone equity – flex-cap, large-cap, mid-cap, small-cap; Global – flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; US equity – flex-cap, large-cap blend, large-cap growth, large-cap value, mid-cap, small-cap; Emerging markets equity – emerging markets; Europe bond – EUR diversified; US bond – USD diversified; Global bond – global un-hedged bond; UK bonds – UK diversified, UK government. Performance is for periods ending on 31 December 2016. Performance is calculated relative to prospectus benchmark. Fund performance is shown in GBP terms, net of fees, gross of withholding tax, with income reinvested, based on closing NAV prices.
Senior investment strategist, Vanguard Asset Management.
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