In The Only Guide To A Winning Investment Strategy You’ll Ever Need, Larry Swedroe dedicated a major portion of the book to the discussion of the Efficient Market Hypothesis (EMH), specifically to explain why investing in passively managed funds is a winning investment strategy.
The Efficient Market Hypothesis asserts that the current market prices on traded assets, e.g., stocks, bonds, or properties, already reflect the total knowledge and expectation of all investors. It is unlikely that any one investor could use the information available to consistently produce above-market returns.
Larry also introduces two other efficiencies in his book — i.e., cost and risk:
Efficient market hypothesis is important to understand because it explains why passively managed funds outperforms actively managed funds.
The main premise of active management is that superior performance can be achieved through research; specifically, by identifying mispriced investments and taking advantage of them. However, the cost of research and management is the first barrier that actively manage funds must overcome to beat their passively managed counterparts.
In other word, one reason why passively managed funds are superior to actively managed funds is their low costs (i.e., expense ratios, management fees, etc.) I demonstrated this concept, where a difference of 0.5% in expense ratio could result in a portfolio that under perform by nearly 15% over the course of 30 years.
The second barrier that actively managed funds must overcome to beat passively managed funds is the costs of trading. The costs of trading include selling costs, buying costs, and the bid-offer spread.
It’s interesting thing to note when information efficiency is lower — i.e., lightly traded stocks, emerging markets, etc. — the cost inefficiency takes over and wipe out any advantage of active management. For instance, information dissemination is slower for smaller stocks, but that advantage is wiped out by the higher bid-offer spread.
Lastly, investors who hold actively managed funds in their taxable account have to contend with taxes. Specifically, there are two that these investors have to deal with:
In short, actively managed funds are unlikely to outperform passively managed funds due to the costs associated with actively managed funds. Moreover, it’s unlikely that active managers can consistently identify and take advantage of mispriced stocks to outperform the indices due to the Efficient Market Hypothesis.
For more information about Efficient Market Hypothesis, and passive investing as a winning investment strategy, I recommend The Only Guide to a Winning Investment Strategy You’ll Ever Need by Larry Swedroe
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