Securities markets are highly efficient and have become progressively more efficient over time as the speed and availability of information to market participants has increased, allowing more timely arbitrage and incorporation of information into securities pricing. While the Efficient Market Hypothesis is often misstated as holding that markets are perfectly efficient, markets represent the aggregate knowledge of all participants within the marketplace and thus operate with greater efficiency over time than any individual market participant can operate. Aside from theoretical arguments supporting highly efficient markets, the available empirical evidence also strongly supports market efficiency. A compelling testament to highly efficient markets is the aggregate long term record of professionally managed active investment portfolios in comparison to passive investment portfolios based on broad based market indices. Numerous studies have demonstrated that professionally managed active investment portfolios do not outperform passive investment portfolios based on broad based market indices over the long run, rather underperforming the latter on the average to the extent of their increased fees and costs, an outcome perhaps best substantiated in the long running SPIVA® Scorecard library maintained by S&P Dow Jones Indices. This remains an elegant empirical proof of highly efficient markets.
The available evidence irrefutably supports the long term superiority of passive indexing strategies over active investing strategies when considering investment returns net of costs and taxes. This does not imply that it is impossible for an active investor to outperform the broad market. However, the broad market has a greater probability of outperforming any individual active investor for any given holding period, with the probability increasing as the portfolio holding period increases. This outcome is unsurprising when considering the Efficient Market Hypothesis and statistical regression toward the mean. Furthermore, total market returns have a zero-sum nature: total market returns must equal the sum of all investor activities in the marketplace, those investors who perform above the mean return must do so at the expense of investors underperforming the mean return (i.e., all investors in the marketplace cannot be “above average”), and the returns on the average actively invested dollar must equal those on the average passively invested dollar less the added costs and taxes associated with active investing. The passive indexing approach is also supported by empiricism, with multiple studies documenting the diminishing probability of active fund managers outperforming benchmark broad market indices in relation to length of portfolio holding period, with outlier active funds exhibiting long term regression toward the mean. The active versus passive investing debate is perhaps most clearly articulated by William Sharpe in his impeccably reasoned essay “The Arithmetic of Active Management”, published January / February 1991 in The Financial Analysts’ Journal.
For a comprehensive discussion of the evidentiary support and academic study of market efficiency and the related active versus passive investing debate, please reference “The Efficient Market Hypothesis and Its Critics” by Burton G. Malkiel, published winter 2003 in the Journal of Economic Perspectives.