The Myth: Everyone is piling into ETFs, and that makes stock markets less efficient.

The argument: The more people invest through indexes and ETFs, the fewer people there are scrutinizing the fundamentals of stock prices to figure out if individual stocks are cheap or expensive. That must make it easier to pick stocks, right?

It’s a catchy idea that sounds reasonable, except it’s completely wrong!

In an earlier video, I explained that there are more analysts than ever following fewer stocks than ever, which is the first argument against this myth. But I’d like to take the myth to task even further.

To fully understand why this myth is wrong, we need to look at what’s known as the Arithmetic of Active Management1. This is a concept that William Sharpe described in the ‘60’s and for which he won a Nobel Prize.

William Sharpe stated two fundamental truths about investing and markets:

  1. before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
  2. after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

The first statement essentially says that for every winner in the stock market, there must be an equivalent loser. Since index investors, by definition, get the market return, that means that for every winning active manager, there must be a losing active manager.

The return on all active funds as a group will match the return on passive funds. Because active funds charge higher fees, they must as a group, underperform passive funds on average.

The Numbers Don’t Lie

For confirmation of this fact, look no further than the annual Standard and Poors Active vs. Passive report1. It shows that the vast majority of active funds underperform the equivalent passive funds over time.

What does this mean for the myth we’re trying to bust? As more and more investors are moving to passive investing, it does mean that there are fewer active investors in the market. But which side do you think is shrinking? Is it the winning active managers or the losing active managers that are switching to index funds?

The argument follows that it is investors who have not beat the market, because of bad luck or high fees, that are switching to index investing. This leaves more of the winning or best active managers to fight it out. It also raises the average. This makes the market more efficient, not less.

I hope this has given you a new way to think about how the market is evolving, and a deeper understanding of the impact of index investing on the market. As always, I love to hear your thoughts, so please don’t hesitate to leave me a comment.