Indexing in Inefficient Markets?

Q:  Does indexing only work in efficient markets?

A:  A common misconception is that indexing only works in less efficient markets—those in which there are fewer participants and in which information is harder to come by.  In asset classes such as small cap stocks and international stocks, the argument goes, there is more opportunity for active management to add value.  A review of actual results in these markets, however, suggests otherwise:  For the 15 years ended 12/31/2009, roughly 85% of actively-managed small cap mutual funds underperformed their benchmark.   Internationally, 56% of developed-market funds underperformed, while 64% of emerging market funds failed to meet the benchmark return.^[i]

These results should come as no surprise, really, when one considers the simple arithmetic of active management.  In a world without costs—management fees, trading costs, and the impact of taxes—one would expect, by simple chance, for half of active investors to outperform while the other half underperform.  Index investors earn the average.  For active managers to outperform, they must do so at the expense of other active investors.  On average, therefore, they must earn the same return as index investors.  But, this is before costs.  After costs (higher management fees, trading costs, etc.), we would expect the majority of active investors to underperform—regardless of the market’s perceived “efficiency.”

ⁱ Phillips, Christopher. “Debunking some misconceptions about indexing.” Vanguard Research Note, December 2010.