EMH and Passive Investing
Broadly put, there are two approaches to investing:
- Active Management: Reliance on the personal judgment, analytical research, and financial models of investment professionals to manage a portfolio of securities (e.g. hedge funds).
- Passive Investing: “Hands-off,” buy-and-hold portfolio investment strategy with long-term holding periods, with minimal portfolio adjustments.
As EMH has grown in widespread acceptance, passive investing has become more common, especially for retail investors (i.e. non-institutions).
Index investing is perhaps the most common form of passive investing, whereby investors seek to replicate and hold a security that tracks market indices.
In recent times, some of the main beneficiaries of the shift from active management to passive investing have been index funds such as:
- Mutual Funds
- Exchange-Traded Funds (ETFs)
The widely held belief among passive investors is that it’s very difficult to beat the market, and attempting to do so would be futile.
Plus, passive investing is more convenient for the everyday investor to participate in the markets – with the added benefit of being able to avoid high fees charged by active managers.
Efficient Market Hypothesis vs. Active Management
Long story short, hedge fund professionals struggle to “beat the market” despite spending the entirety of their time researching these stocks with more data access than most retail investors.
With that said, it seems like the odds are stacked against retail investors, who invest with fewer resources, information (e.g. reports), and time.
One could make the argument that hedge funds are not actually intended to outperform the market (i.e. generate alpha), but to generate stable, low returns regardless of market conditions – as implied by the term “hedge” in the name.
However, considering the long-term horizon of passive investing, the urgency of receiving high returns on behalf of limited partners (LPs) is not a relevant factor for passive investors.
Typically, passive investors invest in market indices tracking products with the understanding that the market could crash, but patience pays off over time (or the investor can also purchase more – i.e. a practice known as “dollar-cost averaging”, or DCA).
Random Walk Theory vs. Efficient Market Hypothesis (EMH)
1. Random Walk Theory
The “random walk theory” arrives at the conclusion that attempting to predict and profit from share price movements is futile.
According to the random walk theory, share price movements are driven by random, unpredictable events – which nobody, regardless of their credentials, can accurately predict.
For the most part, the accuracy of predictions and past successes are more so due to chance as opposed to actual skill.
2. Efficient Market Hypothesis (EMH)
By contrast, EMH theorizes that asset prices, to some extent, accurately reflect all the information available in the market.
Under EMH, a company’s share price can neither be undervalued nor overvalued, as the shares are trading precisely where they should be given the “efficient” market structure (i.e. are priced at their fair value on exchanges).
In particular, if the EMH is strong-form efficient, there is essentially no point in active management, especially considering the mounting fees.
Efficient Market Hypothesis Conclusion
Since EMH contends that the current market prices reflect all information, attempts to outperform the market by finding mispriced securities or accurately timing the performance of a certain asset class come down to “luck” as opposed to skill.
One important distinction is that EMH refers specifically to long-term performance – therefore, if a fund achieves “above-market” returns – that does NOT invalidate the EMH theory.
In fact, most EMH proponents agree that outperforming the market is certainly plausible, but these occurrences are infrequent over the long term and not worth the short-term effort (and active management fees).
Thereby, EMH supports the notion that it is NOT feasible to consistently generate returns in excess of the market over the long term.