How Much Activity Is Enough?
While no one knows exactly how much active security selection is needed to assure markets are efficient (that is, providing the best estimate of the “right” price), it doesn’t take all that much activity to ensure that is the case. Consider that, 60 years ago, there were less than 100 mutual funds, and just a small number of hedge funds. Yet markets were pretty efficient, as the first studies on the performance of active managers showed. At that time, trading volume was a small fraction of what it is today.
More than 40 years ago, Richard Posner, a leading figure in the field of law and economics, contemplated the question of how much activity is needed to keep markets efficient.
In an article co-authored with John Langbein, “Market Funds and Trust-Investment Law II,” which was published in the American Bar Foundation Research Journal, he wrote: “No one knows just how much stock picking is necessary in order to assure an efficient market, but comparisons with other markets suggest that the required amount is small. In markets for consumer durables, homes and other products, unlike the securities markets, the amount of search is highly variable across consumers, many of whom do little or none; trading may not be frequent; products may not be homogenous (no two homes are as alike as all the shares of the same common stock); bids and offers may not be centrally pooled so as to maximize the information available to buyers and sellers. Yet these markets are reasonably efficient, albeit less so than the securities markets.”
Although Posner didn’t hypothesize exactly how much active management is necessary to make prices fair, it’s likely far less than what we currently observe in markets. Why? Consider an auction for art with 1,000 unsophisticated participants and just two sophisticated art historians bidding on behalf of wealthy individuals. Will the two sophisticates be able to buy a Picasso at a cheap price because there are so many unsophisticated buyers? Or, is it more likely that the two experts will engage in a bidding war and set the price at a fair market value? You don’t need many experts to set prices efficiently.
In this example, it’s also possible that one of the 1,000 unsophisticated participants could bid well over what a Picasso was worth and the two sophisticates would not be able to keep this particular market efficient.
However, in the stock market, sophisticated investors can short stocks, driving their prices to the “correct” level. With that said, we also know arbitrage limits prevent sophisticated investors from fully correcting prices, allowing some anomalies to persist even after discovery. Yet despite the existence of these anomalies, active management remains a loser’s game.
Economic theory suggests the marginal cost of searching for mispriced securities should equal the marginal profit associated with exploiting pricing errors. Thus, if assets invested in index funds increase to the point where mispricing becomes easy to identify and profit from, then active investors would re-enter the market until the marginal benefit of active investing once again does not exceed the marginal cost.
It’s also important to recognize that, in addition to the price discovery activities of active investors, issuers of stock play an important role in maintaining market equilibrium/efficiency. If companies believe their stock is too highly valued, they can issue more shares because capital is cheap. Recall the late 1990s. When companies believe their stock is undervalued, they can engage in stock buybacks.
Winner’s Game: Passive Investing
One reason passive management is the winning strategy is that markets are efficient at processing information, making it difficult to gain a competitive advantage. Active managers also bear the burden of the greater costs they incur in the pursuit of outperformance: operating expenses, transaction costs, market impact costs, the drag of low returns on cash holdings and, for taxable accounts, taxes. That’s John Bogle’s “Cost Matters” hypothesis.
With the historical evidence supporting the view that active management is the loser’s game, the trend to passive management among individuals and institutional investors has not only been growing, the pace has accelerated. In light of this, I am often asked: What would happen if everyone indexed?
First, we are a long way from that happening, with perhaps 40% of institutional assets and nearly 20% of individual assets invested in passive strategies. Second, there will always be some trading activity from the exercise of stock options, estates, mergers and acquisitions and, as previously mentioned, from new issuance and buybacks, cash flow needs of investors and so on.
With that in mind, let’s address the issue of the likelihood of active managers either gaining or losing an advantage as the trend toward passive management marches on.