Swedroe: Market Efficiency Doesn’t Matter

Passive strategies still outperform in inefficient markets.

Reviewed by: Larry Swedroe
Edited by: Larry Swedroe

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.

The average ranking for the five DFA funds in these supposedly inefficient asset classes is in the 13th percentile, meaning these passively managed funds outperformed 87 percent of the surviving actively managed funds. If survivorship bias were accounted for, they surely would have outperformed far more than 90 percent of active funds.

What’s more, these figures are based on pre-tax returns. Given that active management typically has significantly higher turnover rates, and the greatest expense for taxable investors in actively managed funds typically is taxes, the percentage of active funds that would have outperformed the DFA funds on an after-tax basis would have likely been in the low single digits.

The table raises a critically important question for investors who believe active management is the strategy most likely to deliver superior results in inefficient markets: If this is true, then how did two of the five DFA funds manage a first-percentile ranking, outperforming virtually all actively managed funds? When you ask that question, the silence is deafening.

Further Evidence From Vanguard, S&P

The literature is filled with studies showing there isn’t any evidence that active management is likely to outperform in inefficient markets. The latest piece in this long line of data comes from Standard & Poor’s September 2015 research report. The report provides a look at the global evidence covering the five-year period 2010 through 2014.

It found that, while in developed countries an average of 76 percent of funds underperformed their respective benchmarks (the dollar-weighted underperformance was 0.4 percentage points), in the supposedly inefficient asset class of emerging markets, an average of 80 percent of funds underperformed their respective benchmarks (the dollar-weighted underperformance was 1.2 percentage points). In other words, active managers did even worse in supposedly inefficient emerging markets.

Further evidence showing that active managers don’t win in inefficient markets comes from a recent study by Vanguard’s research team. Vanguard concluded that once survivorship bias is accounted for, 84 percent of small-cap U.S. funds, 73 percent of non-U.S. developed-market funds and 71 percent of emerging market funds underperformed the average return of low-cost index funds in those same categories over the 10 years ended 2013.

While it’s true that those figures are all better than the 85 percent of large-cap U.S. funds that underperformed over the same period, it doesn’t change the fact that active management clearly was a loser’s game no matter where you looked.

While all the actual evidence demonstrates that active management is the same loser’s game in so-called inefficient markets, you don’t actually need to see any of this evidence to know that active management is the loser’s game in inefficient, as well as efficient, asset classes. All you need is what’s called the “costs matters” hypothesis.

The Costs Matter Hypothesis

William Sharpe demonstrated in his famous 1991 paper, “The Arithmetic of Active Management,” that passive management (the winner’s game) doesn’t depend on market efficiency. Instead, it depends on the simple laws of mathematics, or what John Bogle called the cost matters hypothesis.

Since all stocks (be they small-caps or emerging market) must be owned by someone, and passive investors earn the market return less low costs and (in aggregate) active investors must also earn the market return less high costs, in aggregate, passive investors must earn higher net returns than active investors.


The bottom line is that active management is just as much a loser’s game in so-called inefficient markets as it is in efficient ones (such as U.S. large-cap stocks). It’s a game that’s possible to win, but the odds of doing so are so poor that it’s imprudent to try. Just like the roulette wheel or the craps table, the surest way to win a loser’s game is not to play.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

Larry Swedroe is a principal and the director of research for Buckingham Strategic Wealth, an independent member of the BAM Alliance. Previously, he was vice chairman of Prudential Home Mortgage.