Thursday, March 02, 2006

The Rise (and Fall?) of Indexers

Indexing the market, primarily through ETFs and other passive index-matching investment vehicles has clearly been in ascendancy through the last decade or so.

Just about anyone who reads the financial papers on a regular basis is aware of the dismal record of most actively-managed mutual funds. Very few manage to beat the index they are competing against for any sustained period of time; typically, over a 10 year period, it would be less than 20% beating the index.

So investors around the world have asked the same question and are generally arriving at the same conclusion: If you can't beat the index, then join it (through ETFs or low cost index mutuals).

Recent research by Indiana University professors Bhattacharya & Galpin, confirm this as a world-wide phenomenon - of 39 national markets viewed, only in 4 of them was stock-picking (ie non-index trading) on the rise compared to previous periods analyzed. In the US market, stock-picking peaked at about 70% of all trading activity in the 1960s, and has steadily declined to today's level of just 24% as actively chosen stocks.

The good professors further conclude that the markets can remain efficient to as low a level as 11% actively picked stocks, for index funds to persist on at least an equilibrium level with an actively chosen comparable portfolio.

However, given the continued explosion of index funds of various descriptions, the question arises as to:

  • Exactly when will the typical actively-managed mutual fund begin to consistently outperform index funds? (I can tell you, that you'll see mutual fund sales people dancing in the streets in their Armani suits that day, however) and;
  • How much of an advantage will begin to accrue to the the serious do-it-yourself stock-picker as that day of market inefficiency gets closer and closer?

A couple of thoughts worth pondering as that day draws closer and closer ...


The Confused Capitalist

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