The efficient-market theory states that all publicly available information – be it good or bad – is already priced in all stocks trading on public markets. Therefore, the conclusion goes, it’s not possible for anyone to be a better investor than the market and there’s no point in spending your time doing research anymore: The market is efficient.
How then is it possible that some people out there manage to consistently outperform the market still?
To answer this question, let’s dig a little deeper first!
Are Equity Markets Efficient?
The market price of all publicly traded stocks is nothing else than the aggregate of thousands of individual human opinions! Yes, that is how a market price is found – it’s derived by millions of buyers and sellers who agree to certain prices at certain points in time. If sometimes a family of four can not even agree on what they have for dinner, how can the aggregate of millions of individual, human, opinions, influenced by fear and greed, emotions, and emotional overshooting be correct?
If we read more about the efficient-market theory, we will quickly find the researchers have split market efficiency into different forms of efficiency: Weak, semi-strong, and strong.
Wait, what? Is the market now efficient or not?
· Weak-form efficiency assumes that future prices cannot be predicted by analyzing prices from the past.
· Semi-strong-form efficiency assumes that share prices adjust to publicly available new information very rapidly and in an unbiased fashion, such that no excess returns can be earned by trading on that information.
· Strong-form efficiency assumes share prices reflect all information, public and private, and no one can earn excess returns.
Yes, like a family that can’t agree on what’s for dinner, financial researchers even divided the efficient-market theory into different sub-forms of efficiency.
This is where the market efficiency paradox begins, we are merely scratching at the surface.
The more you research, the more paradox it gets.
First Answer: Inconclusive!
Somehow one could argue the theory itself is responsible for further increasing the inefficiency in the market: Increasingly more people believe in the efficient-market theory and therefore invest most of their assets in passive funds. More believers also mean fewer researchers, less active managers, and ultimately less information being processed professionally and ultimately a much less efficient price-finding process and therefore market.
Believing that one cannot outsmart the market an increasing number of investors have turned to index tracking ETFs. These extremely popular funds mimic the composition of the index at incredibly low costs. In the US there are even a few zero-cost SP500 ETFs available. If the index changes its components, the funds will have to allocate money accordingly.
You may have heard how Tesla’s inclusion into the SP500 made the stock soar higher as ETFs had to rebalance their holdings and purchase Tesla due to the mere fact that it has been included in the index. This had nothing to do with the companies’ fundamentals or financial situation, at all!
On a global scale, regular index rebalancing decisions are responsible for shifts of increasingly more assets whenever they occur as more and more assets are passively invested. The most interesting examples are China and later India, this has tremendous implications for capital flows and sometimes capital controls can be an obstacle for ETFs to correctly represent MSCI indexing decisions.
indexing frenzy
Yes, I agree, by investing in the index you will get the index performance.
That in itself is probably the biggest achievement of John Bogle who made indexing available to the broad masses through Vanguard. It is an awesome achievement. That much is for sure. Before Vanguard, most private investors significantly underperformed. Now they have an excellent low-cost solution at their disposal!
However, yes, and here comes the big, the very big BUT: What would happen if everyone were to invest in index tracking ETFs? What if nobody was investing “actively” anymore?
Did you know that as of early 2023, almost half of all assets are invested passively?
In late 2020 the number was at 45%, up from 25% in just a decade.
Passive likely overtakes active by 2026.
This could be dangerous.
Stay with me on this for a moment please, just imagine what will happen if sufficient people accepted that the marketplace is efficient. Logically, no one would be engaging in active price finding or management anymore, and therefore the overall efficacy of the now “not-so-efficient market” would drop as the diffusion of information into market prices would slow down.
The moment a majority believes the market is efficient and aligns their investment accordingly, that belief will result in the very invalidation of the theory it was created to support, thus forming a paradox:
The Market Efficiency Paradox!
While on the one hand, it’s extremely hard to argue that Bogle is wrong in his crusade against the traditional active management industry: Retail investors have democratically voted in favor of Bogle, moving industry assets to 45% in 2020 vs. 25% in 2010 vs. 10% in 2000 in passively managed solutions.
This rotation into passive investment strategies is a trend that’s bound to continue.
In the 2020’s we enter an era in which the majority of retail and institutional investors believe that the efficient market theory is correct.
Let’s address the big elephant in the room!
When will the paradox come to full effect?
Where is the tipping point?
While we don’t have an answer to this question yet, we believe that as this trend continues. We will see much less efficiency in the stock market pricing mechanism and therefore the future will be an investment environment with much more opportunities for active trading strategies!
Conclusion
We are entering a new world with a majority of assets following one strategy: Passive index tracking. It will once again be lucrative to invest time, efforts, and resources to use data and build a system to invest differently from the vast passively invested herd.
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Invest with momentum,
Matt