passive investing and the paradox of efficient markets

This weekend brings yet another insightful column from Tim Harford, the “undercover economist”.

Why spend time carefully choosing assets to buy, or lavishly paying active fund managers to do the job for you, when … such returns look so similar to the trained eye that it is pointless to try to pick a winner. Another phrase to describe this idea is the “efficient markets hypothesis”. It is often viewed with suspicion because it sounds a bit Reaganite; in fact, it simply means you shouldn’t be too impressed by people who offer you stock tips. ….

[T]he performance of actively managed investment funds … [on average is no better than] passive funds, which simply try to track some sector or market as a whole …. – particularly not when their fees are deducted. ….

Active managers will have us believe otherwise, and occasional bunfights break out over whether actively managed funds are quite as bad as they seem but, for me, the logic in favour of passive investing is persuasive and the data even more so. ….

[On the other hand] If everybody chose [passive funds] …, there would be no reason to expect a happy outcome. ….

This insight has become known as the Grossman-Stiglitz paradox, after [two economists] …  who back in 1980 … [pointed out] that if financial markets were efficient, there was no benefit in paying for any sort of research or analysis; yet if nobody paid for any sort of research or analysis, why on earth would financial markets be efficient?

We passive investors like to congratulate ourselves on avoiding those parasites, the active fund managers, who charge high fees without delivering high returns. Yet we are parasites too, waiting for others to pay for research and then following the herd. ….

Passive investors shouldn’t feel too badly, though. …. If most investors switched to passive funds …, the market would be full of obvious errors and an active approach would pay off again.

Tim Harford, “Pick a fund, any fund …“, Financial Times, 4 October 2014.

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