An investing approach that can break the link between price and portfolio weight, bypassing the return drag caused by cap weighting.
Are markets efficient? The answer depends on who you ask and views tend to be held with near-religious conviction in both the yes and no camps. More importantly, one's views on market efficiency strongly color one's approach to investing-typically choosing between active management and indexing. For many of us, however, these alternatives provide little choice for those frustrated with the hollow promise of active management and the propensity of traditional index funds to ignore mispricing and load up on the most overpriced areas of the market. In this issue, we show that the Fundamental Index® approach offers a new choice for investors.
Investors' approach to investing is built on their views of market efficiency. Proponents of traditional indexes believe that market prices reflect all current information on a company and thus are a fair representation of its value. Accordingly, the pursuit of undervalued or overvalued stocks is a waste of time, as these intensive research efforts will fail to unearth significant opportunities to beat the market.
Naturally, active managers disagree. They parade a seemingly endless list of bubbles and crashes where prices couldn't have possibly reflected value. The natural question, then, is whether active stockpickers can exploit these mispricings (if they exist) for above-market returns. The fund management industry shouts, "Of course! Look at Peter Lynch, Warren Buffett, and Bill Miller." The proponents of indexing claim these stars are the outliers on a wide distribution of results—the lucky few roulette winners at the end of a long night.
Thus, the beliefs of the indexing community can be summed up as (1) prices closely reflect intrinsic value, and (2) active managers cannot reliably beat the market (as proxied by cap-weighted indexes). Meanwhile, the tenets of active management are naturally the opposite: (1) prices deviate, often significantly, from intrinsic value, and (2) active managers can exploit these inefficiencies to beat the market. Figure 1 summarizes these contrasting viewpoints:
Figure 1. Core Beliefs of Active and Passive Managers
Those of us in the Fundamental Index camp have our own opinions. We assert the first and more theoretical definition of market efficiency-that prices align or closely approximate the intrinsic value of the enterprise-to be a bit of a stretch. The peak of the technology bubble produced scores of stocks that now appear today to have been selling dramatically above their eventual worth. Cisco, Nortel, Lucent, and others suffered mind-numbing declines as the euphoria of the Internet (and hundreds of billions of dollars of wealth) evaporated in three short years. Even everyday industries see prices wildly detach from value-witness Krispy Kreme briefly selling for over 150 times earnings (for doughnuts-a 150-year-old product!) in 2001. It is part of human nature to give in to the fad of the day whether it be Dutch Tulips in the 17th century or the Nifty Fifty of the early 1970s. Even in more "normal" times, prices are unlikely to match value-as the eventual true fair value of an equity security is dependent upon potentially decades of future cash flows, market participants would have to have incredible clairvoyance to perfectly match price and value.1 Thus, we in the Fundamental Index camp reject this notion of price efficiency as history is littered with massively mispriced securities.
Turning to the practical side of the market efficiency issue, we ask whether active managers outperform the market indexes after fees. The answer is no. The data do not present a pretty picture. Time and time again, indexes such as the S&P 500 trump the majority of institutional managers and mutual funds, adjusted for survivorship bias, over the long term. Furthermore, collectively, all active managers own the market and thus will earn market returns, less costs. Thus, we agree with those on the passive side of the fence that active managers cannot reliably beat the market, as represented by index funds.
In light of this discussion, let us revisit the comparison of active managers and their indexing counterparts in Figure 2. By breaking the definition of market efficiency into two components and gauging the validity of each, we arrive at a paradox-we agree with both the indexers and active managers! We believe pricing errors exist, but assert that active managers collectively have not and cannot exploit them reliably for above-benchmark returns.