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Look for Winners or Accept the Returns on Market Index

“All the serious money is indexed,” Burton G. Malkiel, Princeton economics professor and former dean of Yale SOM, is quoted to have said in Paul Sullivan’s February 6, 2010, article in the New York Times. Malkiel’s new book, The Elements of Investing, authored with Charles D. Ellis (an active member of the Yale SOM Board of Advisors, as well as a former member of the SOM faculty and the Yale Corporation), suggests that all investors, wealthy included, could do better by investing in index funds. Most people pay dearly for investment advice which is not worth the cost; they are right, of course. But let us also consider a hypothetical world in which this sage advice was widely accepted and all money was invested in index funds. Index funds economize by saving the high costs of evaluating the individual securities as investment prospects. They act as price takers for the market as a whole, as well as for any individual security transactions needed for rebalancing. This means that index funds transact at prevailing market prices, instead of submitting their own limit orders. How are the market prices to be determined when all traders are price takers? To the extent market prices of securities closely approximate their underlying but unobserved fundamental values — the well known efficient markets hypothesis — one can indeed save money by skipping the effort involved in finding mispriced securities and resorting to index investing. But if everyone believed in market efficiency, and resorted to this option, there would be no information in the market, and the market cannot be efficient. Market efficiency requires at least some people to believe that it is not efficient, and continue their search for mispriced securities. This is known as the Grossman-Stiglitz paradox. Fortunately, naturally present noise in markets allows a degree of market efficiency to coexist with the costly search for mispriced securities. “Information people” who spend their time and money on such search are able, on average, to earn slightly higher gross returns at the expense of those who invest without information (e.g., index funds). Only a part of the information produced by the former leaks out to the uninformed investors through market prices, allowing the informed to earn a return on their efforts. However, after the cost of the effort is subtracted, their net returns (on average) are comparable to the returns of the uninformed. Research shows that on the margin, it does not matter on average whether you choose to look for mispriced securities or invest in index funds. What is true on average is not true of every individual. Some may have superior capability to identify underpriced securities. However, of the thousands of people who would like investors to believe in and pay for their investing acumen, the record shows that only a small fraction might have valid claims. When one hires an investment manager, it is not easy to distinguish real talent, as opposed to pretense of talent. Even long records of beating the market may be little more than a lucky run of coin tosses — less likely but possible. Perhaps Malkiel and Ellis have the right advice — stop looking for superior returns, invest in the market index, and passively accept whatever happens to the market as a whole. However, let us hope that not everyone would accept the advice; otherwise the assumptions on which that advice is based will longer be valid. As more money free rides on market information through being invested in the market index, prices become noisier and therefore less efficient, shifting the balance away from index investing. Thanks to this property of how markets function, the volumes of informed and indexed investments tend to retain a mutual balance in which both groups can still earn comparable net returns on average. Shyam Sunder, the James L. Frank Professor of Accounting, Economics, and Finance at Yale SOM teaches Securities Valuation (MGT 948) in the fall (with Prof. Matthew Spiegel). Teams of two students analyze, report, present, and defend their investment recommendations to convince the class acting as the investment committee of a fund looking for superior returns. Visit the course website for selected investment reports from the past offerings of the course.