Gallery:Step 5|Step 5: Manager Pickers

Q&A with IFA: Seeking the Inefficient Asset Class

Gallery:Step 5|Step 5: Manager Pickers

Question: We often hear the claim that some markets are less efficient than others—small company stocks, emerging markets, foreign exchange, and so on. Is there any evidence to support this assertion?

Note: The question above was taken from DFA’s Fama/French Forum. Professor Fama gave this terse response:

“Nothing convincing we know of.”

Professor French, on the other hand, brought forth a detailed refutation that we will explore in this article. French starts with consideration of the “neglected assets” argument which he immediately discards due to “the hundreds of billions of dollars investors spend each year trying to find pricing errors.” French himself published a paper quantifying that number in which he showed that investors in the aggregate would improve their annualized returns by 0.67% by switching from active to passive. French also considered and immediately dismissed the argument that certain markets attract suckers that the smart participants can exploit. Every market has a large number of bright and motivated people pricing securities which is all that is needed for efficiency.

Next, French considers a somewhat sophisticated argument referred to as the “limits of arbitrage” which basically states that mispricings can be expected to occur to a greater extent in markets with high trading costs. One example would be residential real estate where the cost of each transaction is at least 5%, not to mention the large amount of time required. As French points out, the limits of arbitrage put a ceiling and not a floor on the size of pricing errors. While the errors may exist, they are not exploitable for most investors, so they may as well not exist.

Lastly, French considers the argument from the returns data itself that since small cap stocks display more volatility than large cap stocks, they must be priced less efficiently. He demolishes this argument by noting that since the underlying characteristics of small cap stocks such as quarterly earnings are more volatile than large cap stocks, we would fully expect to see higher volatility in their prices, assuming that market participants are pricing them rationally.

Naturally, we at Index Fund Advisors agree with the conclusion of Fama and French, and the data we have seen bears it out. For example, Vanguard1 recently evaluated the ten year records of active funds in five categories (large blend, small blend, foreign large blend, emerging markets, and intermediate-term bond funds). In none of the categories did less than 71% underperform a low-cost index fund. While there may be an inefficient market lurking in some dark corner of the world, our advice to investors is not to waste their time and resources searching for it but instead let the efficient markets work for them. If you would like to learn more about capturing the returns offered by financial markets around the world, please call us at 888-643-3133.

 

1Debunking Some Myths and Misconceptions about Indexing. Valley Forge, PA: The Vanguard Group, April, 2014.