“Reflections on the Efficient Markets Hypothesis: 30 Years Later” Malkiel (2005)

by vonNudge

This paper is by the author of the most famous popular book in favour of the efficient markets hypothesis. Put briefly, this hypothesis states that it is very hard to outperform average market returns on a risk-adjusted basis. The only way to reliably outperform the market over time is by taking more risk (either via leverage or by buying stocks with above-average levels of undiversifiable risk). The efficient markets strategy is then to invest in index funds which provide risk exposure and diversification at a very low cost. It’s a controversial argument which is rejected by many practitioners and behavioural finance scholars. For example, Grossman/Stiglitz show that it can never be strictly true, since active investors need an incentive to collect and process costly information. The market cannot be efficient with nobody processing information to be reflected in stock prices.

When looking at the nudge/behaviour change argument central to this blog, however, this debate is not entirely relevant. All that we require is for naïve investors to make enough errors when picking high-cost actively managed funds, and individual stocks, that they’d perform better if nudged towards low-cost index funds. Malkiel gives us some firm data on actively managed mutual funds in support of this hypothesis.

First, past returns are not indicative of future returns. Funds with high past returns do not persist. In fact, there tends to be mean-reversion, where high performing mutual funds then underperform their benchmarks. And this is made worse by the pattern of money flows to these funds. Most high performing funds achieve their best returns when relatively small. The funds massively swell in size, and then tend to underperform. Although these funds overperform their benchmarks on a time-weighted basis, they often underperform on a money-weighted basis, because their low returns come when there is so much more invested in the fund. These funds, which are the best actively managed funds, actually underperform their average investor.

Second, Malkiel shows the average actively managed fund underperforming the S&P 500 by over 2% a year for both 10- and 20-year samples up to 2003. This is approximately equal to their average cost levels, indicating that choosing low-cost funds is the most important part of making good mutual fund choices (and not looking at past returns). Other papers examined on this blog show that expense ratios are given little weight in investors’ decision making process. I think this is an artifact of the way costs are disclosed, however, and I think this behaviour can be changed.