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The academic big guns behind your humble index tracker fund

Many people have been won over to index funds and passive investing because index trackers are cheap, and it’s not worth paying more for active managers who overwhelmingly fail to beat the market.

But have you ever wondered why index trackers are able to do just as well as tens of thousands of the world’s best paid professionals?

After all, you would be unwise to trust your brain surgery to whoever offers to chop your skull up most cheaply.

And while the relationship is far from perfect (Beats headphones, anyone?) the phrase “you get what you pay for” usually holds true with everything from cars and computers to education and ice cream.

No surprise then that passive investing still feels wrong to so many people.

But as the following video from Sensible Investing explains, when it comes to investing it’s really quite simple.

Share prices at any time reflect the best guess of all those thousands of highly-informed market participants. In theory, the market is literally the most educated estimate of a company’s valuation that humanity can come up with.

Any new information is quickly reflected in the price, too.

Therefore only those with inside (that is, non-public) information will theoretically be able to beat the market, except through luck.

And there’s more.

Even if somebody has some exceedingly rare ability to better predict what all that available information means for the future of share prices – and so outperform – they can only gain at the expense of somebody else.

Any winner must be matched by a loser, and so the overall expectation of active stock pickers must be zero.

The French connection

Something else that’s highlighted in the video is the role of 19th Century French PhD student Louis Bachelier in the evolution of what we now know as the Efficient Market Hypothesis:

At age of 22 Bachelier came here to Paris to study at the Sorbonne. Among the eminent mathematicians whose lectures he attended was the world-renowned Henri Poincaré. It was also in Paris that Bachelier developed an interest in the workings of the financial markets.

After graduating, Bachelier stayed at the Sorbonne to study for a PhD. His specific focus was how stock prices moved. Detailed study of the data led him to conclude that:

  • all the available information is already included in the price of a stock
  • prices react to new information which is, by nature, random
  • therefore, price movements are also random (or, as he rather colourfully put it, no more predictable than the steps of a drunkard).

In conclusion, Bachelier said, “the expectation of the speculator is zero”.

We tend to hear a lot more about the US academics like Eugene Fama and Paul Samuelson who brought Bachelier’s theories to wider acceptance, as well as Jack Bogle who put theory into practice by devising index funds.

Trust a French intellectual to think the unthinkable first!

Check out the rest of the videos in this series so far.

{ 25 comments… add one }
  • 1 Gregory September 18, 2014, 11:56 am

    Frankly I don’t beleive in the Efficient Market Hypothesis but I like passive inex investing because it is extremely hard to beat the market in the long run and because index investing is very very diversified. And cheap!

  • 2 oldthinker September 18, 2014, 12:12 pm


    > Frankly I don’t beleive in the Efficient Market Hypothesis but I like passive inex investing because it is extremely hard to beat the market in the long run


    Do you have an opinion on why it is extremely hard to beat the market in the long run? The efficient market hypothesis implies that this should be the case, but your confidence is presumably based on something else because you do not believe in EMH – what is it?

  • 3 ermine September 18, 2014, 12:43 pm

    I lost 12 minutes of my life to this – is it just me or is a video in incredibly slow method of getting a point across compared to the written word?

    No great quarrel with it, but it gives no reason why you should invest in the stock market at all – after all if your expectation is zero why expose yourself to all the volatility?

    The bit that seems to be missing is that you’re buying a share in some collection of productive assets, and historically productivity has increased a little bit, and it’s a share in that very slow real increase in productivity that makes your capital worth a little more as the years roll by?

    It is that which gives the stock market better odds than a casino. It isn’t a zero sum game, there’s a slight trickle of increasing value over time.

    Without that rider this simply supports the common meme that the stock market is merely an upmarket version of Betfair without the horses

  • 4 Gregory September 18, 2014, 12:55 pm

    @oldthinker Mainly because I’m not a genius. I’m just a common guy. But there are people who can beat the market like Soros.

  • 5 The Investor September 18, 2014, 12:56 pm

    @ermine — The expectation of an investor *in the market* is not zero. The expectation of a *speculator* who bets against the market by trying to pick a portfolio of stocks that will do better than the market is zero.

    (I say this as a known speculator. 😉 ).

  • 6 magneto September 18, 2014, 4:36 pm

    Also dubious about the EMH but huge fan of trackers.
    EMH takes no note, as far as I am aware, of sentiment which we know can change stock prices.
    How can that be reconciled with EMH?
    Prime example Oct 1987, or does portfolio insurance get all the blame?
    All Share Yield has tended to range from 3% to 5%, with outliers at 2% and 6%, for those same stocks.
    Could this be explained purely by changes in economic outlook?

  • 7 Gregory September 18, 2014, 4:53 pm

    „Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund” Warren Buffet

  • 8 grey gym sock September 18, 2014, 4:55 pm

    well, EMH doesn’t implies that nobody will beat the market, but that it’s down to luck if they do. and that the longer the period you look at, the fewer investors will beat the market consistently. toss and coin, and ask a few thousand monkeys to call heads or tails, and about half will be right the first time; a quarter will be right the first 2 times; 1 in 1024 will be right the first 10 times (call them the “lucky tossers”). fund management is a bit like this, except that the monkeys/managers who start off with a run of bad luck tend to be sacked (survivorship bias).

    i don’t 100% believe in EMH, but i think it’s a very good approximation of the truth. looking at fund managers’ records, even if some of them are actually skilled, they are hugely outnumbered by the “lucky tossers”, so how do you tell them apart?

    a further issue is that, even supposing you can identify skilled managers in advance, their fees may well be so high that it cancels out their outperformance – or more than cancels it out.

    EMH can also serve as a useful warning to individual active investors about why they shouldn’t expect to beat the market just because they are smarter and more hard-working than average.

    soros is not a good example of somebody beating the market, because there is no suitable benchmark for currency speculation, etc. however, EMH implies that you can’t get higher returns without taking on more risk, and it looks like soros has taken on a lot more risk than, say, just buying a world equity tracker. and he may well have been lucky; it’s hard to tell when somebody has placed a small number of large bets, a number of which have paid off.

    buffett is perhaps a better example. in that he’s done a lot better than a roughly appropriate benchmark (the US stock market) over the long term, without doing anything obviously much more risky. though there is a possible explanation, on the lines that he was doing something like “factor investing” before it was described by academics: see http://www.etf.com/sections/index-investor-corner/21477-swedroe-unpacking-buffetts-genius.html?fullart=1

    though there is room to disagree about whether “factor investing” is consistent with EMH: http://www.nytimes.com/2013/10/27/business/sharing-nobel-honors-and-agreeing-to-disagree.html

  • 9 diy investor (uk) September 18, 2014, 6:27 pm

    I fully understand the theory but I’m afraid, still remain to be convinced in practical reality.

    Just had a quick look on Trustnet at total returns for the past 3 yrs for Vanguard trackers. The UK All Share (Acc) return is 43.9% and the Lifestrategy 60 (Acc) is 34.3%.

    Over the same period, the average return on my basket (14) of investment trusts is 56.0%.

    Yes, this is a fairly short period to compare but just thought I would throw the figures into the mix to maybe give a little balance to the passive v active discussion.

  • 10 The Investor September 18, 2014, 6:49 pm

    @diy investor — I’m the opposite. I don’t believe the EMH theory is 100% accurate, for similar reasons to @magneto. But I am very sure that most investors would do far far better by acting as if it was entirely beyond doubt correct, and invested mechanically in a portfolio of periodically rebalanced index funds as a result.

    Without wanting to be rude, your anecdotal evidence is just another example of the sort of thing that makes me think that.

    Have you compared that basket of investment trusts over all market cycles? Have you looked how they did over 20 years? Are you fully aware that your investment trusts are (a) geared and (b) that the majority of the sort I believe you invest in from your blog have moved from a discount to a premium? Have you adjusted for risk? (I’m actually a little dubious of that latter point myself but it’s what a market statistician would talk about).

    I like UK equity income trusts, and think they have a decent record, too. I’d recommend them over nearly all other active funds. But I don’t think they disprove the EMH, especially not over what I know you concede is a very short period of relatively bullish market, least of all by looking at them in price (versus NAV) terms. And one that has been hugely beneficial for bond proxy dividend shares to boot. 🙂

  • 11 The Investor September 18, 2014, 6:55 pm

    @magneto — I sort of agree it’s unlikely to be 100% accurate, but don’t think those data points you mention are a silver bullet that kill it.

    The EMH doesn’t say prices need to be all about changes in economic outlook, as I understand it. Rather, it would presume that all market participants are to a greater or less degree aware of the emotionally-driven behaviour of other investors, and would be factoring that into prices, too.

    It doesn’t meant that prices are always “correct” even with hindsight, because events come along that change our understanding of what would have been correct (including events like self-reinforcing change in sentiment), and those events are by their nature unknown and so are not in prices.

    The other thing to realize is that prices transmit pure information themselves. Say I am an amazing stock picker and I’m great at finding undervalued overlooked small cap shares. Beyond a small amount of money, my actions will begin to be noticed and will move the price, which will be noticed by others, and so forth. (This isn’t a bad reason for believing in capitalism, too, incidentally!)

  • 12 diy investor (uk) September 18, 2014, 7:30 pm

    Yes, of course, I am aware of gearing and corresponding risk and no, I have not compared over 20 yrs as the modern day low cost trackers such as Vanguard referred to in my example have not been available for such time-span.

    Whether the evidence is anecdotal – well, just the actual returns over the past 3 yrs. So many of the discussions are based on academic studies.

    Of course, it will be interesting to compare over the longer term and over a number of varying market cycles. Maybe return to this sometime down the line?

  • 13 The Investor September 18, 2014, 7:46 pm

    @diy — Indeed! Also, I was just reflecting that I was a bit harsh (/wrong!) talking about the big equity income funds moving from discounts to premiums over the past three years. That’s more a five year thing. (Doesn’t time fly in a bull market! 😉 ).

  • 14 magneto September 19, 2014, 4:49 pm

    @ The Investor
    “The EMH doesn’t say prices need to be all about changes in economic outlook, as I understand it. Rather, it would presume that all market participants are to a greater or less degree aware of the emotionally-driven behaviour of other investors, and would be factoring that into prices, too.”

    That is an interesting thought. Will need to ruminate on that for a while, and maybe do some re-reading!

    By the way, in his latest book (Rational Expectations) Wm Bernstein references Shiller & Samuelson :-

    Samuels Dictum, markets were micro efficient but macroineffecient.
    In other words that it’s nearly impossible to identify persistently succesful stock and bond pickers, and those who do achieve high returns almost always revert to mean going forward (microefficient). But Samuelson also believed, as do Robert Shiller and the author (Wm B), that from time to time markets go barking mad (macroinefficient).

    See book, page 89, for ungarbled version.

    EMH as a topic is almost as interesting as Fixed Income!

  • 15 rjustice September 19, 2014, 5:17 pm

    Hi, I am filling my ISA and pension nicely with passive funds but I am lucky enough to have some left over to invest that I cannot fit into tax wrappers. As I am higher rate tax payer then I am thinking that I should put any small cap holdings I have/want into this as they should pay smaller dividends (compared to mid and large) and I can avoid tax on capital growth by using up my CGT allowance when necessary. Does anyone have any thoughts on this? Or seen any good articles?

  • 16 The Investor September 20, 2014, 9:23 am

    @rjustice — I do a similar thing with my money outside tax shelters. That said, you don’t need to go for small cap holdings, there are large caps that pay no dividends (I own shares in Amazon, for instance) and also some ETFs and investment trusts.

    As your portfolio grows and gets really size-able, it can be an advantage to have some ‘unbundled’ holdings in individual shares, because you can use your CGT allowance as you say, and also net off some CGT losses against gains for greater tax efficiency, and helping you to defuse future CGT bills.

    There are of course lots of risks and downsides though, as with all active strategies.

  • 17 magneto September 20, 2014, 10:47 am

    One other possibility is iShares non-distributing (accumulating) ETFs :-
    e.g. SWDA MSCI World

  • 18 David September 20, 2014, 1:07 pm

    But won’t accumulating ETF’s still have income tax due on the income that is accumulated? (I realise I’m stepping into a potential minefield or reporting and non-reporting, distributor and non-distributor funds, which I’m sure others can actually explain!)


  • 19 rjustice September 22, 2014, 7:53 am

    I am completely passive at the moment but i have been considering in trying to buy a selection of equally weighted small cap value shares to reduce fees/get access to proper small caps but in order to buy enough to diversify is probably not worth the hassle and may only have small effect on costs.

    My understanding is that even with accumulation funds i still need to declare dividends reinvested by the fund otherwise this would be a good option.

  • 20 magneto September 22, 2014, 9:48 am

    My understanding is that even with accumulation funds i still need to declare dividends reinvested by the fund otherwise this would be a good option.

    Perplexed. Funds such as ETFs and ITs decide how much they can pay out of their received income (i.e. received dividends from underlying investments). Even in distributing funds the proportion of dividends received that is paid out is at the discretion of the fund managers, is not usually 100%, and the investor is taxed on that final payout, not the underlying dividends received by the fund.

    Is any more information available?

  • 21 rjustice September 22, 2014, 10:05 am

    Monevator did an article on this in 2011. I cant link as on my phone but have a search, it clears this up i think.

  • 22 The Investor September 22, 2014, 11:06 am
  • 23 magneto September 22, 2014, 3:59 pm

    Thanks for the link.
    The knowledge here is formidable.

    So if an investor can find an IT or other fund at low cost not distributing dividends, that’s OK by the IR, but not so for ETFs! What a puzzle.

    Was wondering about the CGT as a nightmare issue, and the link confirms worst fears.

    “You don’t have to pay capital gains tax on the dividends that have fattened your fund. So when you come to fathom the capital gains on your accumulation units (and as your resultant psychic scream reverberates around the universe), make sure you deduct any reinvested income from the total gain, otherwise you’ll be overpaying.”

  • 24 magneto September 22, 2014, 4:50 pm

    See on re-reading link, not just an ETF problem.

  • 25 grey gym sock September 23, 2014, 9:16 pm

    yes, funds and ETFs are in the same boat – all the income they generate counts as part of your taxable income.

    investment trusts have a little more flexibility. you only have to look at the income they actually pay out. however, as part of the conditions for keeping IT status, they have to pay out (i think) 85% of their income. (they need IT status to avoid paying tax internally on their capital gains.)

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