When investing, individuals can either accept the market return by investing in an index or try to do better with active management. This is applicable for both bond and stock investments. Investing in an index is a low-cost strategy that will insure a market return, while active management may give superior returns in the short run, but its higher expenses often negate any long-term advantages.
The rationale for indexing is based on the efficient-market hypothesis developed by financial economists. When I was in college and graduate school during the 1970s, this theory was very popular, though its influence has lessened somewhat in recent years. Essentially, what the theory implies is in a market dominated by informed investors, stock prices accurately reflect current information. Prices change as information changes, whether as perceptions of the economy or a particular company change.
Obviously, the efficient-market hypothesis does not work perfectly, as there are times stocks are not priced appropriately. While skilled investors can take advantage of these opportunities, few can consistently do so over different market cycles. That is why many fund managers will do well for a number of years with a certain market environment but see their performance suffer when circumstances change.
One point to also be aware of is that market efficiency is not constant across stocks and countries. For example, among large U.S. corporations, the market is reasonably efficient but among mid-sized and smaller companies, the level of efficiency declines, as less analysts are following these firms. Likewise among emerging market countries, where accounting standards are more questionable stocks are less likely to be trading at fair prices.
What this means for an investor is that if someone is investing in large U.S. companies, the investor will probably be better off with an index fund rather than paying the higher fees for active management. The difference in fees is huge, as the cost for an index fund for the S&P 500 is approximately1% per year, while the cost for active management is typically 1% to 1.25% per year. For smaller companies, a skilled manager has a greater chance of exploiting market inefficiencies to justify paying higher fees, rather than an index.
Unlike other products or services, investment management is one area where paying higher prices does not necessarily imply better results. Investors frequently see stellar returns from certain managers and expect this performance to be replicated. Unfortunately, investment returns are highly variable, so it is important not to be overly influenced by short-term results. Investing in an index fund may not be exciting, but is certainly appropriate for a portion of someone’s assets.
