Eugene Fama
Three American professors won the Nobel Prize for Economics this year (it’s not technically a Nobel, but we’ll ignore that). Of the three, Eugene Fama is perhaps the least well-known and celebrated amongst investors. As one of the major proponents of the efficient market hypothesis, his work has largely focused on how money managers will not outperform index investing. Fama, you could say, brought the intellectual weight to John Bogle’s activism and Vanguard’s success.
The billionaire hedge fund investors and successful traders who have made a living out of finding and exploiting market inefficiencies would like to disagree that the market is purely efficient, although it must be emphasized that Fama’s work never suggested a purely efficient market exists. However, his idea of “semi-strong-form informational efficiency” argued that it is impossible to beat the market systematically over time with public information, because the market will efficiently price assets based on all public information. To read more on Fama’s work, check out the full Nobel prize paper giving background on his and the other laureates’ work.
This is not the place to argue for or against an efficient market. However, the growing popularity of Fama’s position, popularized by Bogle and enshrined in a number of popular personal finance books, has an impact on the market. This is changing the market in ways that most people don’t notice.
Ironically, this impact has been buoyed by one of the greatest market crashes in human history: the crisis of 2008, which caused tremendous capital outflows from the stock market. The market has never fully recovered. If you look at the trading volumes for any large cap U.S. stock from 2008 to today, you’ll see a steady decline. People just don’t want to invest in the market anymore.
Part of this is a feeling that they cannot beat the market. Yet money has to go somewhere, which is partly why bonds rallied since 2009 (look at TLT or even JNK), until rates began to rise this year. Still, people feel a need to own stocks, but they do not trust their or a money manager’s ability to provide alpha.
Here are where index funds come to the rescue.
Part of the rising popularity of ETFs has been due to the rise of the efficient market hypothesis. If you can’t beat the market as a whole, the thinking goes, buy a fund that tracks an index and let the rising tide lift your boat. You might buy a couple of losers with the winners, but, so the EMH thinking goes, that’s going to happen just as much if you try to pick stocks. So look for the lowest cost index fund and pour your money there.
The result has been great for Vanguard, with inflows helping the firm reach new records almost monthly. So you have more and more money in things like VTI and BND and VXUS, and less money in actively-managed mutual funds.
Taken to its extreme, the more money that is in index funds, and the more stock prices will rise just based on capital inflows and outflows. In other words, stock prices will go up not because of individual stock fundamentals, but more as a result of fund mandates and the makeup of indices. The less money out there buying on fundamentals, theoretically the more opportunity someone with deep knowledge of fundamentals can take advantage of asset mispricing.
We haven’t seen the emergence of an anti-indexing fund that specifically arbitrages inefficiencies caused by the rise in index funds. We probably never will. But we will probably see the alpha from fundamental investors rise over time. This is because, the less people there are playing the game, the more room there is for those left to win.