The case for index investing rests on the index fund's cost advantage and how representative it is of its actively managed peers, not market efficiency.
A version of this article was published in the June 2016 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
Intuitively, the case for index investing seems the strongest for more-efficient areas of the market, like U.S. large-cap stocks. Here, information is easy to obtain and widely disseminated. So prices should reflect all available information, making it difficult to consistently outperform without taking on greater risk. In less-competitive markets, it may be easier to obtain an informational edge, or identify mispriced securities, giving savvy investors a better chance to outperform.
In theory, that story makes sense, but it often breaks down in practice. According to data published in the June 2016 installment of Morningstar's Active/Passive Barometer, 14.8% of all actively managed U.S. large-blend funds survived and outpaced their passive counterparts during the 10-year period ended June 30, 2016. The success rates for the U.S. small-blend (26.1%), foreign large-blend (33.1%), intermediate-term bond (39.0%), and diversified emerging-markets stock (32.4%) Morningstar Categories, which many view as less efficient, were higher but still shy of 50%.
It is tempting to view active managers as informed investors with a chance to collectively outperform, profiting at the expense of less-sophisticated individual investors. But the reality is that many of the supposedly less-efficient areas of the market are still fairly competitive. And even when that is not the case, active investors' asset-weighted average performance should be similar to a representative benchmark gross of fees. Outperformance is a zero-sum game, and a negative-sum game after accounting for fees. If there are greater opportunities for skilled managers to outperform in less-efficient markets, it is also true that unskilled managers here can hurt investors more.
So the case for index investing isn't necessarily weaker in less-efficient markets. Rather, it depends on how well the index represents the waters where active managers are fishing, the size of the cost hurdle active managers must clear, and investors' confidence in their ability to identify skilled managers and/or winning investment strategies. The remainder of this article will focus on the first two factors to examine the case for index investing in the U.S. small-blend, foreign large-blend, intermediate-term bond, diversified emerging-markets stock, foreign small/mid-blend, and high-yield bond categories.
Fees are one of the best predictors of future relative performance (the lower the better). As index funds' cost advantage over their actively managed counterparts increases, so does the strength of the case for investing in them. Exhibit 1 highlights one of the lowest-cost index funds in each category that I will examine here.
In all four equity categories, the index funds' cost advantage relative to the median active fee exceeded 1.2 percentage points at the end of June 2016. In other words, more than half of all actively managed funds in these categories have to generate annualized gross returns that are at least 1.2 percentage points higher than these exchange-traded funds to offer the same returns net of fees. That's no small task. However, there are lower-cost actively managed options available that should have a better chance to outperform. The cost advantage relative to the median active fund was the smallest in the high-yield bond category.