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Academic Support for the Use of Index Funds

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

The rationale for using index funds springs from efficient market theory. The literature, extending back over two generations in support of efficient market theory is compelling.

Beginning with Paul Samuelson of MIT (Nobel Prize in Economics, 1970) “Proof That Properly Anticipated Prices Fluctuate Randomly” Industrial Management Review Spring 1965. Samuelson showed that:

  • Market prices are the best estimates of value.
  • Price changes follow random patterns.
  • Future stock prices are unpredictable.

About that time, Eugene F. Fama, of the University of Chicago coined the term efficient market in “Random Walks in Stock Market Prices,” Financial Analysts Journal, September/October 1965 (reprinted January-February 1995). Fama conducted extensive research on stock price patterns and extended work on the unpredictability of stock prices and finds that prices quickly incorporate information. His “Efficient Markets Hypothesis,” asserts that prices reflect values and information accurately and quickly. Furthermore, it is difficult if not impossible to capture returns in excess of market returns without taking greater than market levels of risk. Finally, investors cannot identify superior stocks using either fundamental information or technical analysis.

Michael Jensen’s “The Performance of Mutual Funds in the period 1945-1964″ Journal of Finance December 1965, was one of first studies of mutual funds that indicated active managers under perform indexes. This work was shortly followed by A.G. Becker Corp showing identical results for institutional managers.

Burton G. Malkiel first captured broad attention for the concept with A Random Walk Down Wall Street 1973 ed. In it, Malkiel complains that “Fund spokesmen are quick to point out you can’t buy the market averages. It’s time the public could.” His call would soon be answered.

The first real support and test of the efficient market hypothesis occurred in 1973 when two Chicago banks, American National Bank, and Wells Fargo Bank launched the first S&P 500 index funds for institutions. However, it took two years to sign up the first major client, New York Telephone Company. Their $40 million investment launched the index fund era. The rest, as they say, is history. It wasn’t until 1977 that Roger Ibbotson, and Rex Sinquefield published Stocks,Bonds, Bills and Inflation an extensive returns database for multiple asset classes. This work, updated annually, covers returns since 1926, and established the first base line or benchmarks for judging the performance of active managers in diverse markets.

Of course, nobody would or should care if it weren’t backed up by real world experience. The evidence is conclusive beyond a reasonable doubt. The failure of active management to deliver value over and above the benchmark market returns is absolute and undeniable.

A pioneering study by Gary P. Brinson, L. Randolph Hood, and Gilbert Beebower, “Determinants of Portfolio Performance” (published in the Financial Analysts Journal July-August 1986), demonstrated that the single largest driving force behind investment results in the country’s 91 largest pension plans was the policy decision allocating between stocks, bonds and cash. Attempts to either market time or select individual issues generally reduced performance as compared to the index results.

Mark Carhart supplies perhaps the most comprehensive and authoritative recent paper on mutual fund performance, “On Persistence in Mutual Fund Performance” Journal of Finance 1997. He finds that only very poor performance reliably persists, and that once adjusted for size and book-tomarket weighting, mutual fund alphas virtually disappear.

You can imagine that active managers find this concept threatening. After all, they might have to go out and get a real job!

However, academic support for the active managers’ position is almost nonexistent. Nobody is out writing papers that tell us how to reliably beat markets. Active managers carp, but produce no evidence. What they do produce is advertising and public relations. They fill the media with propaganda. They can afford to. But, standards for proof in advertising and public relations are quite low ý right down there with campaign promises. But, with a big enough media budget you can shape popular opinion. Spend enough and The Big Lie becomes conventional wisdom.

For a while, active managers took refuge in foreign or smaller, less liquid, less efficient markets. Garrett Quigley, and Rex A. Sinquefield’s paper published in the Journal of Asset Management, February 2000 “Performance of U.K. Equity Unit Trusts” An examination of the performance of U.K. equity trusts (similar to our mutual funds) finds, net of expenses, that they reliably under perform the market. Like Carhart, the study also finds that good performance does not reliably persist but bad performance does.

However, the evidence that even developing markets are so efficient that local or insider knowledge is unable to add value is becoming equally evident. A January 1997 paper by David Booth of Dimensional Fund Advisors, “The Value Added of Active Management: International Single Country Funds” finds that on a country by country basis conventional active management underperforms benchmarks internationally due to extra trading costs. In May 2000, another Booth paper, “Investing in Emerging Markets” illustrates the inability of active managers to add value in emerging markets. Again, real world experience backs up academic literature and research. The Vanguard Emerging Market Index Fund (the oldest and largest of the emerging market index funds) has had admirable performance against the actively managed funds through both good and bad markets since inception.


Support for indexing and passive investment techniques is almost unanimous in academic literature. The efficient market hypothesis is the dominant economic model explaining market behavior and price changes. Indexing provides the most effective and economical method of capturing the world’s market performance, and is the benchmark against which other investment styles must be measured. An investor must have a compelling reason to abandon this simple reliable and effective technique.