If you’ve spent any time on Biglaw Investor, you’ve noticed one thing – we’re fans of index funds. Index funds raise returns, lower costs, and reduce risk while simultaneously simplifying your portfolio.

Though the favorable evidence for index funds is undeniable, many, my past self included, find their success perplexing. Index funds are by definition passive, tracking the performance of a basket of securities. Actively managed mutual funds, at least intuitively, should be able to produce higher returns than a passive index fund.

History, however, has shown that this isn’t the case. Index funds consistently outperform actively managed funds.

The Efficient Market Hypothesis (EMH), possibly the most famous bit of research to come out of financial economics, offers a compelling explanation for this paradox. Essentially, the EMH holds that markets are efficient, with all relevant information already incorporated into the current valuation of a stock. Since all relevant information is already incorporated, the short-term price fluctuations of a stock, or any other security for that matter, will follow a “random walk,” i.e., be random.

This explains why active funds underperform index funds. They’re trading on random fluctuations; according to the EMH, what they’re doing is little better than gambling.

At first, the EMH seems to raise more questions than answers. Do stock prices really fluctuate randomly? Are financial markets really efficient? Don’t worry. We only need to go slightly deeper into the EMH to resolve these common questions.

The efficient market hypothesis

Let’s frame our discussion of the EMH around economist Eugene Fama’s, Nobel Laureate and developer of the EMH, definition of the hypothesis. We’ll go sentence by sentence.

An “efficient” market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market prices of individual securities, and where important current information is almost freely available to all participants.

Here, Fama defines what an efficient market is. The definition is a mouthful but taken piece by piece the underlying meaning turns out to be straight forward.

“Rational, profit-maximizers actively competing…” is the jargony economics way of saying people are trading with each other.

“…[T]rying to predict future market values of individual securities” simply means people are trying to figure out what a security, for example a stock, will be worth tomorrow.

The last part, “ …[W]here important current information is almost freely available to all participants,” means that everyone has access to all relevant information.

Putting these three parts together, we get a simplified definition of an efficient market. Namely, an efficient market is a market in which profit motivated traders all have access to the same information.

In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future.

Fama uses more straightforward language here. He argues that in efficient markets, since everyone has all relevant information and is trying to make a profit, the price of securities reflects all available information. Consequently, nobody can make a profit by analyzing market information because that information has already been analyzed and incorporated into security prices.

Fama sums up the EMH in this way:

In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

Short and sweet, and now that we’ve gone step by step the EMH doesn’t seem as jarring a conclusion.

The contention

The actual logic of the EMH makes sense. If everyone has access to all information, it seems almost a truism that you cannot use that same information to turn a profit.

The contention comes when we question how efficient actual financial markets are. When we think of real-world markets, inefficiencies seem to run rampant.  Just in the last year we’ve experienced GameStop and NFT mania, accusations of insider trading at the Federal Reserve, and the rise and fall of SPACs. The list goes on.

Despite these seemingly obvious market inefficiencies, over fifty years of research supports the EMH. We can subdivide the EMH into three versions – strong, semi-strong, and weak. Each version has progressively more evidence in its favor, with the strong version being highly contentious to the weak version being virtually proven.

Strong: The strong form of the EMH holds that all information, including insider information, is priced in. Some research supports this version, but there’s also evidence to the contrary.

I’m not a proponent of the strong version of the EMH; it seems pretty obvious that insider information isn’t priced into stock valuations. If the strong version of the EMH is true, why do pharmaceutical stock prices spike upon FDA approval of a new drug. Why does a company’s stock fall upon the news of a beloved CEOs unexpected retirement?

Semi-strong: The semi-strong form holds that all publicly available information is priced in. There’s an overwhelming amount of research in favor of this version, though actual practitioners vehemently disagree. (For obvious reasons, if everyone subscribed to the semi-strong version of the EMH they’d be out of a job.)

Beyond the literature, this version of the EMH seems intuitively correct. If public information wasn’t incorporated, people, or more than likely large financial institutions, would arbitrage away these inefficiencies and collect a hefty profit.

Weak: The weak form concedes that there may be information, both publicly available and insider, not incorporated into asset prices but steadfastly holds that trading strategies based on technical analysis (e.g., chart reading) don’t work. There’s no room for debate here. No publicly known pattern of past prices — neither the “cup with handle,” the “head and shoulders,” nor the host of other colorfully named patterns — have been shown to have statistically significant predictive power of future prices.

The EMH in action

Now that we know a little more about the EMH, let’s jump back to our comparison between index funds and actively managed mutual funds. If I’ve done my job, the reason why index funds outperform their active counterparts should now be clear.

Index funds accept market efficiency and try to raise returns by minimizing transaction costs. Jack Bogle, founder of Vanguard, a major player in the index fund market, nicely explains this concept with his Cost Matters Hypothesis. (Yes, Bogle named his own hypothesis after the more famous EMH. With his characteristic dry humor, the name pokes fun at the grand language of the EMH which we experienced earlier.)

Actively managed funds reject market efficiency and try to outperform the market through either technical or fundamental analysis. These fund managers market their years of financial services experience to ostensibly show an ability to yield superior returns.

If the EMH is true, we’d expect to see index funds outperforming active managers. If it’s false, we’d expect the opposite. The superior performance of index funds over the last half a century speaks for itself. Market efficiency is very, very real.

Some common objections

Some of the claims of the EMH are unintuitive and are frequently met with a standard set of objections. Claiming experienced managers with decades of experience not only don’t but can’t improve the return of a fund runs contrary to received wisdom.

1. Some people make money actively trading

Obviously people make money actively trading. People also make plenty of money gambling. In both situations, the carnage behind every rare individual success is omitted. The EMH doesn’t claim it’s impossible to make a profit actively trading, only that it’s random. What would falsify the EMH would be an investor who earns excess returns above the market return over a statistically significant time period. This almost never happens.

2. Buffett and Lynch made, and Buffett makes, above market returns consistently

There’s an argument for even the unicorn managers being lucky, too. It’s rare, but some people will flip heads 50 consecutive times and that luck eventually wears. Lynch’s success faded away in the 90s and Berskhire regressed back to the mean in the 2000s and early 2010s though it’s last several years have been successful.

I think this takes the EMH too far.  There are some people who are so good at analyzing information that they can make a profit even in hypercompetitive global financial markets. Everyone may have access to almost the same information, yes, but if you can come up with a novel way of analyzing information or synthesizing information together, you effectively create new information which you can then use to turn a profit.

I still index though. The reason being, it’s almost impossible to identify once-in-a decade managers before they go on their winning streak. After they start winning, their portfolios either become too big to keep yielding above market returns (the fate of Lynch and Buffet) or the fund goes private (the most famous example being Renaissance’s Medallion Fund). Do you think you can identify the next Peter Lynch or Warren Buffett before he or she goes on their run? I know I can’t.

3. Investment banks spend billions annually on research. Why would they do this if markets are efficient?

The EMH doesn’t claim that all markets are always and everywhere efficient. Markets become efficient, remember, when profit maximizing participants are working to outperform each other. The research done by investment banks and other large institutional players is the work that causes global financial markets to be efficient.

So, what does that mean for my investments?

Everyone’s financial situation is different. There’s no one size fits all solution. Though index funds will likely yield impressive long term returns, any investment carries risk.

That being said, if you find the EMH convincing, index funds are superior to actively managed mutual funds, all else held equal.

While buying a total stock market index fund is simple, there’s plenty of nuance in the indexing world if you’re the type who wants to optimize their financial life. Biglaw Investor has dozens of articles discussing all aspects of index funds. Try starting with this article on a basic three index fund investment strategy.

For those who’d like to incorporate index funds into their portfolio but don’t want to spend their free time doing their own portfolio management, check out BLI’s vetted list of financial advisors. All are fee-only and have experience working with lawyers.

Joseph Parise

Joseph Parise A junior at the University of Buffalo, Joseph grew up in New York and is majoring in Philosophy and Economics. He is currently taking a gap year to study for the LSAT exam and to serve in the US Air Force Reserves.

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