PART III
Fund Types and Comparative
Performance, Efficient Markets,
Asset Allocation, and
Morningstar Analysis
Chapter 7
Efficient Markets and
Mutual Fund Investing :
The Advantages of Index
Funds
JUSTIFICATION FOR USING INDEX
FUNDS
• Traditionally, the justification for using index
funds has been the argument that our
securities markets tend to be reasonably
efficient. The efficient market hypothesis
(EMH) has been a central proposition of the
field of finance for over 40 years. Eugene
Fama (1970) in an early survey of EMH defines
an efficient market as one in which security
prices always fully reflect all available
information.
• When information arises about an individual
company or about the stock market as a
whole, that information gets reflected in share
prices without delay. Thus, even an
uninformed investor will find that the current
tableau of share prices accurately reflects all
the information that is known to the market.
In such a situation, it would be fruitless for an
active portfolio manager to switch from
security to security in a vain attempt to buy
“undervalued” securities and sell “overvalued”
ones.
• Such an attempt to gain above-average
returns would accomplish nothing but to
increase transactions charges as well as the
taxes that must be paid by the mutual fund
shareowner.
• The EMH is associated with the view that
stock market price movements approximate
those of a random walk. If new information
develops randomly, then so will market prices,
making the stock market unpredictable apart
from its long-run uptrend.
• Thus, neither technical analysis—an attempt
to derive the future movement of stock prices
by studying charts depicting the past
movements of market prices—nor
fundamental analysis—the attempt to predict
future stock returns from a “fundamental”
analysis of accounting data, future corporate
investment strategies, competitive conditions,
and the like—will allow professional portfolio
managers to achieve abnormal (risk-adjusted)
returns.
• I have suggested (Malkiel, 1973), largely in jest,
that a blindfolded chimpanzee throwing darts at
the stock pages could select a portfolio that
would do as well as the experts. In fact, the
correct analogy is to throw a towel over the stock
pages and simply buy an index fund, which buys
and holds all the stocks making up a broad stockmarket index.
• In recent years, many financial economists have
come to question the efficient market hypothesis.
At least ex-post, there seem to be several
instances where market prices failed to reflect
available information.
• One celebrated example during the late 1900s
is when 3Com spun off 5 percent of the Palm
shares it owned. Based on the market price of
Palm, the 95 percent of Palm still owned by
3Com was worth more than the total
capitalization of the parent company.
Moreover, periods of large-scale irrationality,
such as the technology-Internet bubble of the
late 1990s extending into early 2000, have
convinced many analysts, such as Robert
Shiller (2000), that the EMH should be
rejected.
• In addition, some financial econometricians have
suggested that stock prices are, to a significant
extent, predictable from past returns or on the
basis of certain valuation metrics, such as
dividend yields and price-earning ratios. See, for
example, Campbell and Shiller (1988a,b),
DeBondt and Thaler (1995), Fama and French
(1988), and Lo and MacKinlay (1999).
• But indexing can be an optimal strategy even if
markets are occasionally or even often inefficient.
To understand why this must be so, consider the
next logic. All of the securities in any market must
be held by someone. These investors as a whole
must earn the overall return of the market.
• If the market produces an overall return of 8
percent in any average year, then investors as
a group must earn the same 8 percent before
any investment expenses. Of course, there are
always some stocks that produce aboveaverage returns, and some investors will earn
above-average returns in any particular period.
But not everyone can be above average. We
cannot live in Garrison Keillor’s mythical Lake
Wobegon, where all the children are above
average. Thus, investing must be a zero-sum
game, as is illustrated in Exhibit 7.1.
• If some investors are fortunate enough to be
holding the best-performing stocks, then some
other investors must be holding the poorerperforming ones. All investors as a group hold all
the stocks, and it must be the case that they earn
the overall market average return before
expenses.
• But mutual funds charge a variety of expenses.
There are, for example, administrative costs of
collecting and distributing dividends and
preparing reports for the fund’s shareowners and
for the government. There are also investment
management costs for the portfolio managers
who perform the research analyses to determine
which securities the fund will own.
• Suppose that these costs amount to 8/10 of one
percentage point per year, or 80 basis points. In
that case, the situation will resemble that
depicted in Exhibit 7.2.
• If in an average year the market produces an 8
percent rate of return, the average investor will
earn only 7.2 percent after expenses. Moreover,
after expenses, most investors will underperform
the overall market average, based on the total
capitalization of all the outstanding stocks. After
expenses, investing will not be a zero-sum game;
investing will be a negative-sum game.
• From this analysis, the advantages of indexing
can be seen clearly. Since index funds do not
hire security analysts to pick what are believed
to be the best securities and since index funds
are buy-and-hold investors who generate
limited turnover, index funds can be managed
at minimal expense. Indeed, low-cost index
funds and ETFs can be acquired at expense
ratios of 10 basis points or less (i.e., less than
1/10 of 1 percent). The advantage of indexing
is that it allows the investor to achieve the
market return at minimal expense.
• We can summarize the advantages of index
funds in this way. If markets are reasonably
efficient and generally reflect whatever
information is available, then there will be
little scope for professional investors to select
portfolios of stocks that outperform the
market. Stocks of companies with superior
prospects will already have their prices fully
reflect those prospects. Therefore, active
management is unlikely to find large numbers
of mispriced securities that will result in
consistent above-average results.
• But even if markets are often or even usually
inefficient, it still must follow that most
investment managers will underperform the
market. All investors as a group must earn the
average market return before expenses. The
underperformance of active managers must
reflect the additional expenses that they incur
in running active portfolios. In the next section,
we examine the evidence based on the
historical returns of equity mutual funds to
test whether indexing is an effective strategy
in practice.
EVIDENCE FROM U.S. INDEX FUNDS
• Evidence from actively versus passively
managed equity mutual funds in the United
States strongly supports the efficient market
hypothesis. Most investors have been better
off investing in index funds. Passive index
funds typically provide higher net returns to
the investor than actively managed mutual
funds.
• The Standard & Poor’s (S&P) 500 Index is the
most popular index of large-capitalization
(large-cap) stocks in the United States. The
index represents about 80 percent of the total
capitalization of the U.S. equity market. The
most popular index funds in the United States
(as well as very popular ETFs) have been
indexed to the S&P 500 or to an equivalent
500-stock large-capitalization index (see
Exhibit 7.3).
• Exhibit 7.3 shows that over long periods of time,
over 60 percent of actively managed large-cap
equity mutual funds in the United States have
been outperformed by an S&P 500 Index fund
(see Exhibit 7.4).
• Exhibit 7.4 shows that the average equity mutual
fund in the United States (including all categories
of funds) has underperformed the index by
almost 1 percentage point per year over the 20
years ending December 31, 2008. This difference
can be explained by the higher expenses of
actively managed funds.
• The typical active fund carries an expense ratio
that is considerably higher than that of a passive
index fund. Moreover, active funds have much
higher portfolio turnover, leading to higher
trading costs (see Exhibit 7.5).
• An example of the superiority of index fund
investing over the long run is shown in Exhibit 7.5.
The exhibit compares the performance of all the
U.S. equity funds that existed in 1970 with the
return of the S&P 500 stock index. There were
358 equity mutual funds in existence in 1970.
Note that only 117 of these funds survived until
2008. The other 241 funds were closed or were
merged into other funds.
• These 241 nonsurvivors were undoubtedly the
poorer-performing funds since the more
successful funds tend to stay in business. Thus,
these data are tainted by “survivorship bias.” We
can only compare the long-run performance of
surviving funds with the S&P 500 stock index. The
exhibit shows that most actively managed mutual
funds experienced performance that was inferior
to the index. Indeed, one can count on the fingers
of one’s hands the number of equity mutual
funds that outperformed the S&P 500 stock index
by more than two percentage points or more per
year (see Exhibit 7.6).
• Exhibit 7.6 documents the lack of persistence
in equity fund performance in a rather
dramatic way. The exhibit lists the topperforming 19 U.S. equity mutual funds over
the period from December 1993 through
December 1999. These were the funds that
enjoyed average annual returns that were at
least twice as large as the returns for the stock
market as a whole. The portfolio managers of
these funds were lionized by the press and
treated like rock stars in the popular financial
magazines.
• Their above-average returns were generated,
however, by concentrating their portfolios in
stocks tied to the Internet. A worldwide
bubble in such stocks burst during the first
quarter of 2000. The exhibit shows that during
the next six year period, these funds suffered
severe losses and significantly
underperformed the stock market as a whole.
EVIDENCE IN FAVOR OF PASSIVE
MANAGEMENT
IN WORLD FINANCIAL MARKETS
• Does the evidence in favor of passive
management hold outside the United States?
The United States has very liquid, transparent,
and efficient stock markets. This may not be
the case in the rest of the world, particularly
in the world’s less developed emerging
markets. In this section, I examine the case for
indexing the markets outside the United
States (see Exhibit 7.7).
• Turning first to Europe, we can examine the
performance of active European portfolio
managers. Exhibit 7.7 presents the
comparison. We see that over two-thirds of
the actively managed large-cap European
funds were outperformed by the MSCI Europe
index. Similar results can be shown for global
equity managers. Exhibit 7.8 examines the
investment returns earned by 414 global
equity managers compared with the MSCI
World Index.
• Well over half of the active managers failed to
outperform the passive world index. Even in
emerging markets, many of which are far less
efficient than markets in the developed countries,
passive management appears to be a winning
strategy. Exhibit 7.9 indicates that about twothirds of the active managers of emerging-market
funds were outdistanced by the index.
Paradoxically, the very inefficiency of the trading
markets in many emerging markets, with
relatively large bid–ask spreads and a variety of
transactions charges (including stamp taxes on
security transactions), makes it difficult for active
managers to outperform even in less efficient
markets.
ACTIVE VERSUS PASSIVE
MANAGEMENT
IN THE BOND MARKET
• Next I examine the efficiency of passive
management in the bond markets of the
United States and Europe. Exhibit 7.10
presents the results for the United States. It
appears that indexing is a particularly effective
strategy in the bond markets. Bond funds
appear to be commodity-type products.
• Because passively managed funds charge
lower management fees, it turns out that very
few active bond portfolio managers are able
to achieve net investment returns after
expenses that match the net returns of lowcost bond index funds. In Europe, few of the
active bond managers were able to
outperform their respective benchmarks.
Exhibit 7.11 shows the results for the 10-year
period ending December 31, 2008.
COSTS ARE IMPORTANT
DETERMINANTS
OF NET RETURNS
• Not all index funds investing in U.S. equities
are created equal. There are some domestic
index funds with annual expense ratios of as
much as 100 basis points (one percentage
point per year).
• A high expense ratio destroys a basic advantage
of index funds. Every basis point of expenses
lowers the net return earned by the investor.
Some U.S. index funds and exchange-traded
(index) funds are available with an annual
expense ratio of 10 basis points (1/10 of 1
percent) per year or less. These are the funds an
investor should favor. Index funds with expense
ratios greater than 20 basis points per year
should be avoided. The industry average expense
ratio for actively managed funds is about 100
basis points per year.
• Foreign index funds and ETFs tend to have higher
expense ratios than domestic funds. Low-expense
broad international index funds (indexed to the
Morgan Stanley Capital International EAFE index
of equities in developed foreign markets) might
carry an expense ratio of about 25 basis points.
(The industry average expense ratio is over 150
basis points for actively managed non-U.S. funds.)
EAFE stands for Europe, Australasia and the Far
East, and this index contains all the large
corporations in the developed nations of the
world that are domiciled outside the United
States.
• Index funds specializing in emerging markets
carry even higher expense ratios. Low-cost
funds and ETFs may have annual expense
ratios between 25 and 50 basis points. In
addition, there may be a small purchase
charge to defray the fund’s costs of buying
securities in the less liquid emerging markets.
While sales loads (charges of 300 basis points
or more) should be avoided by investors,
purchase charges of 50 basis points or less for
funds that hold illiquid securities are often
required.
• Similarly, index funds holding emerging
market or other illiquid securities may impose
redemption charges on investors who
liquidate their fund shares after a very short
holding period. Such charges are meant to
discourage short-term trading that would
subject the fund to potentially large trading
costs, which hurt the long-term owners of the
fund’s shares.
• Costs are just as important for actively
managed as they are for passive index funds.
A statistical analysis of the net returns from all
diversified mutual funds over the 14-year
period 1994 through 2008 reveals that the
higher the net returns to investors are, the
lower the expense ratio of the fund. Moreover,
the higher net returns earned by fund
investors, the lower is portfolio turnover (i.e.,
the less the portfolio manager tends to trade).
Excessive trading generates transaction
charges in addition to the portfolio manager’s
fees and administrative costs.
• Portfolio turnover therefore tends to reduce
the net returns available to the investor. In
addition, trading can often be very tax
inefficient. To the extent that high turnover
tends to generate realized capital gains (and
often short-term capital gains that are taxed
at regular income tax rates), portfolio turnover
reduces after-tax returns even further.
Investors who hold their funds in taxable
accounts will want to avoid funds that employ
substantial portfolio turnover.
• Exhibit 7.12 shows the effect of expenses on net
returns. The exhibit compares the net returns of
all diversified equity mutual funds that have high
versus low expense ratios. The high-expense
funds in the exhibit have expense ratios in the top
quartile (the top one-quarter) of all funds, while
low-expense funds are considered those with
bottom-quartile expense ratios. In preparing the
exhibit, expenses are calculated by adding the
explicit expense ratio of the fund to estimated
turnover costs. Every one percentage point of
turnover is assumed to increase expenses by one
basis point.
• As the exhibit indicates, the net returns to
investors from the funds with the lowest
explicit expenses and turnover are more than
200 basis points higher than the returns of the
high-expenses funds. In judging the merits of
actively managed funds, investors should
prefer those with low expenses and low
portfolio turnover. Of course, index funds and
ETFs, with their rock-bottom expense ratios
and very low turnover, are the quintessential
funds designed to minimize investment costs.
MUTUAL FUNDS VERSUS ETFs
• As indicated, ETFs are index funds that trade
like stocks. They can be bought and sold at any
time during the trading day, unlike mutual
funds, which can be purchased and redeemed
only at their net asset value calculated at the
end of each trading day. How should an
investor decide whether to buy index mutual
funds or exchange-traded funds?
 ETFs have three important advantages.
 1. They tend to carry lower expense ratios than
mutual funds.
 2. They can, at least in theory, be more tax
efficient than mutual funds. If a mutual fund was
forced to sell appreciated securities to meet
redemptions from the holders of the fund’s
shares, it could be required to realize capital gains
that must be apportioned to the fund’s
shareholders.
• ETFs create and redeem shares only in large
blocks and only with large investors and
traders. Because the creation and redemption
of units of ETFs serve to ensure that the ETF
sells at (or very close to) net asset value, any
sales of securities to meet redemptions are
not considered taxable events.
3. ETFs can be traded during the day, not
simply at the closing net asset value at the
end of the day. This third advantage should be
treated with some skepticism, however.
Investors are unlikely to benefit from timing
their purchases and sales during the trading
day. Indeed, to the extent that investors
attempt to “time” the market with ETFs, they
are unlikely to improve their return over those
earned by the buy-and-hold investor.
• ETFs have a disadvantage, however, in that
purchases and sales incur brokerage charges.
Transactions in (no-load) mutual index funds
do not incur transaction charges. Even if a
discount broker is used to purchase and sell
ETF shares, there are commissions to pay as
well as the bid–ask spread. (Purchases are
made at the “ask” price while sales are made
at the “bid” price, which is lower. Therefore,
an investor who purchases at one time and
sells at another will incur the cost of the bid–
ask spread.)
• How should an investor trade off the lower
annual costs of many ETFs with the additional
transactions charges involved with buying and
selling ETFs?
• The answer is relatively straightforward. If you
will be investing a large sum in an index fund (say
$10,000 or more), you are likely to be better off
with a low-cost ETF. If, however, you are making
periodic contributions (say $100 a month) into an
index fund that is part of your retirement
portfolio, a mutual fund is far and away the
better alternative.
• The transactions costs of putting small amounts
regularly into an ETF are likely to be prohibitive.
Similarly, if you are retired and are drawing
money out of your retirement nest egg, you will
be better off keeping the money you will soon
need in mutual funds rather than in ETFs. In any
event, there are a wide variety of expense ratios
for different mutual funds and ETFs. Some mutual
funds have even lower annual expenses than ETFs.
Before making any fund investment decision, be
sure to check the actual charges associated with
any investment you are considering.
STOCK MARKET RETURNS VERSUS
INVESTOR RETURNS
• It is customary in calculating mutual fund returns
(as well as the historical returns from equity
investments in general) to measure the returns
earned by a buy-and-hold investor who buys at
the start of the period being measured and holds
the investments until the end of the period. Thus,
when Ibbotson Associates (2008) reports that
equity returns in the United States have averaged
9.6 percent per annum from 1926 through 2008,
those are the returns earned by an investor who
buys at the start of 1926 and holds throughout
the entire period.
• The actual returns of investors are determined,
however, not only by the average annual
returns of the market index, but also by the
timing of their purchases and sales in and out
of the market. Moreover, individual investors
may deliberately move in and out of various
market sectors over time. Hence, the actual
returns of individual investors may differ
substantially both from overall stock market
returns and also from the long-run rates of
return of the mutual funds they hold.
• We can measure the actual returns earned by
equity investors by calculating dollar-weighted
returns rather than returns to the buy-andhold investor. A simple numerical example,
taken from an article by Ilia Dichev (2007), will
illuminate the difference between buy-andhold returns and investor returns. Suppose an
investor buys 100 shares of XYZ Company at
$10 per share at the start of period 1. By the
end of period 1, the stock doubles to $20 per
share, at which time the investor purchases
another 100 shares. Then the stock falls back
to $10 per share at the end of period 2.
• The normal return calculation yields the result
of a zero rate of return over the two-year
period. (The stock started and ended at $10
per share.) That would be the correct return
for the investor who bought at the start of
period 1 and sold at the end of period 2. But
for our hypothetical investor who bought 100
shares both at $10 and $20 per share and
then sold at the end of period 2 at $10, the
result was a negative return ($3,000 was
invested and then sold at the end of period 2
for $2,000).
• Indeed, that investor’s internal rate of return was
−26.8 percent per annum. While the buy-andhold return gives a reasonable estimate of the
return for holding the stock over the entire
period, it will be a very poor measure of the
actual returns of investors whose capital flows in
and out of the market vary over time.
• When there are significant correlations between
the timing of capital contributions into the equity
market and withdrawals from the market, then
dollar-weighted returns will tend to differ from
buy-and-hold returns. There is considerable
evidence that capital flows into the equity market
are significantly correlated with past returns.
• One of the insights from the field of behavioral
finance is that investors are often influenced by
herd behavior. They tend to buy stocks when
everyone is optimistic and sell stocks during times
of ubiquitous pessimism. Specifically, individuals
tend to put money into the stock market after the
market has experienced relatively high returns
and optimism prevails and take money out of the
stock market following periods in which the
market has declined. See, for example, Ikenberry,
Lakonishok, and Vermaelen (1995) and Loughran
and Ritter (1995).
• Because of these correlations, dollar-weighted
returns will differ systematically from buy-andhold returns. Dichev (2007) found that the return
differential is substantial. The return differential
was 1.3 percentage points for exchange-traded
stocks during the period 1926 to 2002. The return
differential between dollar-weighted and buyand-hold returns for Nasdaq stocks was 5.3
percentage points per year from 1973 to 2002. In
all cases the dollar-weighted returns are lower
than the buy-and-hold returns because individual
investors tend to add money to their investments
at particularly inopportune times.
• The next two exhibits illustrate the problem.
Exhibit 7.13 superimposes data on cash flows
into equity mutual funds with the behavior of
the S&P 500 stock index. The exhibit shows
that new cash flows into equity mutual funds
are significantly higher following increases in
stock prices. Indeed, the largest inflows into
equity mutual funds occurred during the last
quarter of 1999 and the first quarter of 2000,
exactly at the peak of the Internet bubble in
the stock market.
• The exhibit also shows that record withdrawals
from equity mutual funds occurred during the
third quarter of 2002, just at the bottom of the
stock market. Huge withdrawals were also made
as the stock market sank in the fourth quarter of
2008.
• This tendency of individuals to put their money in
the stock market (and take money out) at
inopportune times is what I have called the
timing penalty. The situation is even worse,
however, because investors also suffer from what
can be called the selection penalty, shown in
Exhibit 7.14.
• Not only did more money flow into the stock
market than ever before during the Internet
bubble, but those fund flows were concentrated
in high-technology growth mutual funds,
precisely the part of the market that turned out
to be the most overvalued. Note that during the
fourth quarter of 1999 and first quarter of 2000,
there were significant outflows from “value”
mutual funds, precisely the funds with the most
attractive relative valuations. So not only did
more money flow into the market at an
inopportune time, but investors tended to put
their money into exactly the kinds of stocks that
were experiencing the biggest recent gains.
• This tendency of investors to follow what have
recently been the attractive sectors in the
stock market is another factor responsible for
the substantial differential between buy-andhold returns and dollar-weighted returns. The
tendency for investors to alter the
composition of their mutual fund portfolios
exaggerates the differentials between the
overall returns to the stock market and the
returns earned by the average investor that
result from inopportune market timing.
STYLE OR FACTOR TILTS IN MUTUAL
FUNDS
• Many mutual funds, whether actively
managed or indexed, employ certain style or
factor tilts in composing their portfolios. For
example, some mutual funds specialize in
smaller companies—those whose market
capitalizations are below the average
capitalization for traded companies in general.
Other funds concentrate on so-called value
stocks—those stocks that sell at relatively low
multiples of their book values and earnings.
• Some indexed market mutual funds are
broken up into value and growth components
or into small-cap and large-cap portfolios. The
Morningstar mutual fund service uses nine
breakdowns to describe the style focus of the
fund. Funds are categorized by a nine-box grid,
where funds are categorized on one axis as
being invested in small-, medium-, and largecap stocks, and on the other axis by style (i.e.,
invested in value or growth stocks or in a
blend of the two).
• Considerable recent interest had been shown in a
new set of indices that are weighted by certain
fundamental factors, such as sales, earnings,
dividends, or book values, rather than by
capitalization. The best known of the new
fundamentally weighted indices that claim to
improve on cap-weighted indexes is the Research
Affiliates Fundamental Index TM (RAFI). The RAFI
index contains 1,000 stocks weighted by
fundamental measures of book value, earnings,
and so on, and has outperformed traditional
large-cap indices, such as the S&P 500 Index and
the Russell 1000 by margins of over 300 basis
points per year during the early 2000s.
• Such performance has emboldened the
proponents of the Fundamental IndexTM (FI) to
claim that this new method of indexing could
replace the old paradigm of capitalizationweighted indexing. See, for example, Arnott, Hsu,
and Moore (2005) and Arnott, Hsu, and West
(2008).
• In my judgment, the reason for the ability of FI
portfolios to outperform certain market
benchmarks during the period from 2000 through
2006 is that FI relies on the two factor tilts that
researchers have understood for years.
• To the extent that earnings and book values
are some of the factors used to weight stocks
in the portfolio, FI will systematically
overweight value stocks and underweight
growth stocks. Moreover, since FI
underweights stocks with high market
capitalizations relative to fundamental factors,
there will be a tendency for an FI portfolio to
contain smaller-capitalization stocks than
those in a traditional cap-weighted index.
• Along literature in empirical finance has
isolated a value effect in asset pricing. Studies
such as Basu (1983) and Keim (1988) have
shown that stocks selling at low prices relative
to their earnings (P/E) and book values (P/BV)
have generated higher returns for investors.
Similar results have been shown for stocks
selling at low multiples to their sales. One can
interpret such findings as being inconsistent
with efficient markets.
• Portfolios made up of stocks with low P/BV ratios
earn excess risk-adjusted returns when risk is
measured by beta from the Capital Asset Pricing
Model (CAPM). But any test of market efficiency
is a joint test of the relationship of return to P/BV
and the efficacy of CAPM’s beta to fully measure
risk. According to Fama and French (1992), the
ratio of price to book value itself is a risk measure;
therefore, the larger returns generated by low
P/BV stocks are simply compensation for risk.
• Investigators such as Banz (1981) have also found
a strong relationship between company size
(measured by total market capitalization) and
returns. Smaller firms appear to generate higher
returns than large firms. Again, the interpretation
of these results is controversial. The excess
returns of small firms can be interpreted as an
inefficiency. The interpretation of Fama and
French, however, is that both P/BV and size are
risk factors in addition to beta. Low P/BV stocks
are often those in some financial distress, and
small stocks may be far more sensitive to
economic shocks than are larger firms.
• Over the period from 2000 through 2005, there
was a particularly strong value effect as well as a
small-firm effect. The bursting of the Internet
bubble in early 2000 produced extremely poor
returns for the overpriced large-cap growth
stocks that were the market leaders during the
late 1990s. FI portfolios were not alone in
performing very well over the early 2000s.
Managed as well as index funds focusing on value
and small-cap stocks all tended to outperform the
broad market indexes.
• One direct method of measuring the factor
tilts inherent in FI portfolios is to perform a
regression analysis of the monthly FI returns
in the United States against a Fama-French
three-factor model. Fama and French (1993)
argue that the CAPM should be augmented by
two additional risk factors: company size and
the market price to book (M/B) ratio. Thus,
risk is captured by CAPM’s beta, M/B, and an
equity capitalization (size) measure.
• If one performs such a regression over the period
from January 1979 through December 2008, it is
possible to show that the FI return can be fully
explained by the three Fama-French risk factors,
as has been shown by Jun and Malkiel (2008).
The coefficient of determination of a regression
of FI returns and the three Fama-French risk
factors is 0.96, and all of the coefficients of the
factors are highly significant. Moreover, a zero
alpha, or excess return, is generated by the FI
method of weighting the portfolio. In addition, it
is possible to replicate the FI returns with a
variety of ETFs that employ similar factor tilts.
• We need also to maintain some degree of
skepticism concerning the long-term
productivity of value and size portfolio tilts.
From the mid-1960s to the present, value
mutual fund managers have usually
outperformed growth managers (although not
during the late 1990s). Fama and French (1992)
come to the same conclusion. In earlier
periods, however, from the late 1930s to the
mid-1960s, growth stocks appeared to be the
persistent winners.
• There appears to be considerable mean
reversion evident in the time series when
measured over a very long time period.
Indeed, Exhibit 7.15, which measures the
relative performance between mutual funds
with growth and value mandates, shows that,
over more than a 70-year period, the
performance of both types of funds was
essentially the same. A similar kind of mean
reversion can be shown to exist between
large- and small-capitalization stocks.
CONCLUSIONS
• This chapter has examined the efficiency of
equity and bond markets and the efficacy of
passive (index fund) compared with active
portfolio management. If securities markets
were characteristically inefficient, we would
expect professional portfolio managers to
achieve excess performance over the returns
earned by the market as a whole.
• I interpret the inability of professional
portfolio managers to outperform passive
capitalization-weighted index funds as
powerful evidence that securities markets
around the world are generally efficient. To be
sure, markets make mistakes—sometimes
egregious ones, as during the time of the
Internet bubble of late 1999 and early 2000.
But there is no evidence that professional
investors are able to recognize such mispricing
ex ante and to adjust their portfolios.
• As a result, many professional portfolio
managers have adopted what is called a core–
satellite strategy. The core of the portfolio is
invested in low-cost index funds. This
guarantees broad diversification and no risk
that at least a part of the portfolio will
underperform a broad market benchmark.
Satellite portfolios can employ specialized and
undiversified equity managers with far less
risk than if the entire portfolio were actively
managed.