Some thoughts on index funds & market efficiency (including some empirical material)
Currently there are a lot of articles in the financial press about the perceived “fight” between active and passive asset management styles.
The passive guys make the point that on average, after fees, active funds have to underperform against the index and low-cost index funds, which is difficult to counter. On top of that, “alpha” created by large active funds is not very persistent.
From the active side, there is the argument that if there is too much money invested in index funds, market efficiency will suffer and stocks will go up and down together because not enough people are analyzing single stocks. If stocks go up and down together without reflecting fundamentals, at some point in time “good stocks” should be too cheap and bad stocks to expensive. Which then should be some easy money for any good stock picker.
Is the market already inefficient ?
This argument reasonable at first but is there any evidence that the market is less efficient ? Let’s look for instance at the DAX 30, the major German index. It is hard to come up with good numbers but I do think that maybe between 10-15 % of the DAX is somehow invested via index funds with a clear trend towards more index ownership.
So let’s look how the DAX constituents have performed so far this year (as of Nov. 2nd). The Dax itself ytd is down -2,8% This is the YTD performance of the constituents:
|INFINEON TECHNOLOGIES AG||16,14%|
|HENKEL AG & CO KGAA VORZUG||11,72%|
|DEUTSCHE POST AG-REG||7,92%|
|FRESENIUS SE & CO KGAA||0,86%|
|DEUTSCHE BOERSE AG-TENDER||—|
|FRESENIUS MEDICAL CARE AG &||-4,70%|
|MUENCHENER RUECKVER AG-REG||-6,10%|
|DEUTSCHE TELEKOM AG-REG||-12,19%|
|PROSIEBENSAT.1 MEDIA SE||-17,15%|
|DAIMLER AG-REGISTERED SHARES||-18,97%|
|BAYERISCHE MOTOREN WERKE AG||-22,01%|
|DEUTSCHE BANK AG-REGISTERED||-45,08%|
So we can clearly see that the actual performance of the constituents is VERY different and interestingly almost no stock moves like the index.
However those numbers alone are not a proof. Theoretically, there could have been a much higher dispersion of returns in the past. So what one can do is to calculate the historic dispersion of the returns of the constituents vs. the return of the index. As a measure for dispersion, the standard deviations seems to be the appropriate measurement.
The following chart shows the dispersion of the Dax constituents for the last 20 years on an annual basis (annual performance, over 20 years):
Just by looking at the chart, at least for the last 10-15 years, I don’t see that there is a clear trend for less dispersion. However one big caveat here: The underlying data is a cheap “cut and paste” job. I did not have the correct constituents for every year, rather the older the data the less reliable. I also weighted the constituents equally and not according to their index weight.
Just for fun I did the same (crappy cut & paste) analysis for the Dow and there it looks more interesting:
Here it there seems to be a certain trend, especially the current year looks weirdly “narrow”. So for the US we might see some preliminary evidence that returns have become narrower around the index return in the last years, although this can quickly change if we run into a crisis scenario.
Finally, if we compare the DAX and the DOW, we can see that in the past 20 years, the 30 Dow constituents did trade in narrower bands around the index than the 30 DAX constituents:
Overall it looks that at least with regard to this measure, the US market seems to be more efficient than the German one which in my opinion should not come as a big surprise. Especially in times of crisis, US stocks seem to be more stable than German ones.
So what does that tell us ?
I think especially for the US market there seems to be a certain effect in play which reduces the dispersion of returns of the large stocks around the index return. One reason could be that more and more money goes into index funds, however it is always hard to really prove this. It could also be that for some reason the fundamental development of the index constituents is more connected than it was in the past.
If index funds would explain all this, then in my opinion, stock picking could become interesting again in the future.
For the German DAX so far the effect doesn’t seem to be observable. As my data is not very good, this could be a problem of my data or index ownership in Germany is behind the US.
Nevertheless I do think that keeping an eye on return dispersion within indices is something very useful in order to find out if structural opportunities might arise at some point in time.
I think there is much more to write about active vs. passive but that will fill a couple of posts in the future.