Index Funds & the Efficient Market Hypothesis (EMH)

How to Use EMH to Maximize Returns With Index Funds

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The Efficient Markets Hypothesis (EMH) is an investment theory that explains how and why most active investors fail to "beat the market" in the long term. EMH theorizes that since all publicly available information about a particular investment security is reflected in the price, investors can't gain an advantage on the rest of the market. This supports a passive investing approach.

Index Funds and Efficient Markets Hypothesis (EMH)

If you are familiar with the Efficient Market Hypothesis (EMH), you know that it essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. For example, the price of a stock at any given moment reflects all public information, such as financial statements and any news that may impact the respective company's financial outlook.

Therefore no amount of analysis can give an investor an edge over other investors. This is one of the primary reasons why investors invest in index funds. It is the "if you can't beat 'em join 'em" philosophy. But what if some information is not as widely known for some areas of the market as in other areas? Wouldn't this mean that some areas of the market are less "efficient" than others? If so, it would make sense to use an index fund for the efficient areas and actively-managed fund for the less efficient areas.

Types of Stock Funds Best for Index Investing

You don't need to be a stock analyst or mutual fund manager to know that information about some publicly traded companies is more readily available, and therefore more widely known, than others. For example, most financial media coverage focuses on large-capitalization stocks of companies, such as Wal-Mart (WMT), Apple (AAPL) and Microsoft (MSFT).

A majority of large-cap stock mutual fund managers fail to beat the best S&P 500 Index funds over long periods of time because there is much more information available on the larger companies than the smaller ones. Therefore, it takes more effort in the form of research and relative market risk to outperform the broad market indexes.

If more effort is required for investors to gain an advantage in the large-cap U.S. stock segment of the market, this extended effort makes it even more difficult to compete with index funds that can gain an advantage with lower expense ratios. This is because lower expenses generally translate to higher returns (or at least a beginning performance edge) over the more expensive actively-managed funds.

Combining Index Funds With Active Funds

A good way to build a portfolio for the most advantageous way to combine the wisdom of indexing with active investing is to use one of the best S&P 500 Index funds for the large-cap stock allocation and actively-managed funds for the remaining portion. This takes advantage of passive investing for the more efficient areas of the market, such as large-cap U.S. stocks, and utilizing active investing for the less efficient areas.

For example, a good strategic model to follow is the Core and Satellite portfolio design where the index fund is the "core" at around 30 or 40% allocation and a combination of small-cap stock, foreign stock, a bond mutual fund and perhaps some sector funds to round out the portfolio.

In this strategy, you'll satisfy your respect for the Efficient Market Hypothesis but also your alter ego that wants to stretch for some extra returns. Best of all, you'll be able to stop changing large-cap stock funds every few years when they start losing to the S&P 500!

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.