Swedroe: Market Efficiency Doesn’t Matter

November 04, 2015

In a recent discussion on the Advisor Perspectives website (it was in response to an article I wrote on the performance of Third Avenue Management’s actively managed funds), someone commented: “I am, for the most part, a proponent of passive investing, especially in asset classes (such as domestic equity) where the great majority of active funds historically have underperformed the index. That being said, there appear to be asset classes and funds that do tend to outperform.”

This assertion reflects a widely held view that, while the efficiency of the market for asset classes such as U.S. large-cap stocks is so great that attempting to add value (or generate alpha) through individual stock selection and/or timing the market isn’t liable to produce positive results, active management is likely to add value in less informationally efficient markets. International small stocks and emerging market stocks are generally used as the poster children for inefficient markets.

While it’s not surprising there’s a desire by Wall Street to keep this idea alive (since they need investors to believe it so they can continue charging high fees), the evidence shows that this simply is not the case. One doesn’t have to look very hard to demonstrate the fact that active management is just as likely, if not more so, to fail in what are considered less informationally efficient markets as they are to disappoint in informationally efficient ones. All one has to do is to look at the performance rankings provided by Morningstar.

With that in mind, we’ll check the performance rankings of passively managed mutual funds offered by Dimensional Fund Advisors (DFA) in these asset classes. (Full disclosure: My firm, Buckingham, recommends DFA funds in the construction of client portfolios.)

Passive Funds Vs. Inefficient Markets

The table below provides the 15-year percentile performance rankings for the firm’s international small and small-value funds, as well for its three emerging market funds (large, small and value). The table covers the 15-year period ending Oct. 20, 2015. A ranking of 1 is the highest.

Keep in mind that the data is heavily biased because it does not take into account survivorship bias. Roughly 7 percent of all actively managed funds tend to disappear each year, and the longer the time frame we examine, the worse the survivorship bias becomes.

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