the idea of index funds was conceived in
the 1970s and received immediate support
from some of the smartest academics and
economists in the world at the time
industry practitioners on the other hand
laughed at the idea index funds were
even called unamerican who wants to be
average the first index fund that could
be accessed by retail investors was
launched by Vanguard in 1975 despite the
long term existence of index funds
actively managed funds have completely
dominated the investment fund market
until recently in the u.s. passive funds
have doubled their market share since
2006 increasing from 17% to 34% of the
investment fund universe at the end of
2016 a similar trend has been present in
Canada with the market share of passive
funds increasing from 6% in 2007 to 11%
at the end of 2016
people in general are becoming
increasingly aware of fees and
performance and there is ever mounting
evidence that favors index investing is
the most sensible approach so what
happens if everyone invests in index
funds I'm Ben Felix associate portfolio
manager at PWL capital in this episode
of common sense investing I'm going to
tell you why index funds aren't going to
break the market
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the failure of actively managed funds
has played a significant role in the
growth of index funds most active
managers underperform their benchmark
index one of the explanations for their
under performance is that markets are
efficient a term that was coined by
Nobel laureate Eugene fama it means that
security prices reflect all available
information in an efficient market an
active manager does not have an
information edge because anything that
they can know about a stock is already
included in the stocks price the only
way to beat an efficient market is to
accurately predict the future which is
very hard to do consistently most people
that believe in market efficiency do not
believe that they are perfectly
efficient they believe that markets are
efficient enough that it is extremely
difficult to know when someone who
profits from a trade was skilled or just
lucky the way that markets get efficient
is by having a lot of people buying and
selling stocks based on the information
that they have all of the active
managers who are spending resources to
research stocks in an effort to make a
profit are injecting the information
that they have into the price of those
stocks
these aren't mom-and-pop operations
either the largest and most
sophisticated investors in the world are
the ones placing most of these trades if
markets are efficient you can't beat the
market consistently and indexing is the
smartest way to invest but markets can
only be efficient if there are enough
people trying to beat the market
wait what that's a paradox and it
actually has a name it's called the
Grossman Stiglitz paradox it was
introduced in a 1980 paper titled on the
impossibility of informational e
efficient markets that action of them
swooping in and profiting would attract
other active managers to do the same you
can think of it like an equilibrium if
too many people index some active
managers may profit but by doing so they
will push the market back toward being
efficient markets are probably not
perfectly informational e efficient all
of the time but there are efficient
enough that it is very difficult to beat
them consistently as index funds
continue to grow there was no way to
know exactly when markets would cease to
be efficient in a way that could be
exploited consistently but Eugene fama
and Ken French the guys that introduced
the idea of market efficiency explained
in their 2005 paper disagreement tastes
and asset prices that it depends on who
turns to passive investing if the
misinformed and uninformed or bad active
managers turn passive then market
efficiency will actually improve if the
well informed active managers turn
passive then markets could become less
efficient but even if an active manager
with the good information turns passive
the effect might be very small on market
efficiency if there is still sufficient
competition amongst the remaining active
managers fama and French also explained
that costs are an important factor if
the costs to uncovering and evaluating
relevant information are low then it
doesn't take much active investing to
get markets to be efficient in a 2014
paper pasture stambha and Taylor
explained that skill and competition
have both been increasing in the world
of active fund management index
investing is growing but it's still
small in comparison to the long
entrenched world of active fund
management even if index funds do
continue their current growth trajectory
there will always be investors who are
motivated enough to absorb the
additional risks and costs of active
investing in an attempt at achieving
higher returns with the decreasing costs
of information and increasing skill and
competition amongst active managers it
is likely that markets will remain
mostly efficient for a long time my name
is Ben Felix of pwl capital and this is
common sense investing I'll be talking
about a lot more common sense investing
topics in this series so subscribe click
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I want these videos to help you make
smarter investment decisions so feel
free to send me any topics that you
would like me to cover
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