What I have learned about how markets are made efficient comes mostly from Dr. Brook who is a managing partner with Dr. Charlton at B.H. Equity (he's the guy who developed the Student Managed Investment Fund – aka Spider).

Obviously there are a lot of people in this country alone that effect the earnings of a company which then affect the information that traders end up with. But, it's the active traders and investors interpreting that info and acting on it that makes the market efficient.

The simple answer is that information drives markets. The faster the information comes to markets, the better. The better the information, the more accurate the [potential] stock price.

What constitutes “the best” though is determined by traders giving a rational analysis of the information they are given within the context of their lives and work (based on whatever their pre-existing knowledge is) and then acting on their knowledge for profit.

If they fail, then the information wasn't “the best”. It's like…it always gets me to hear people say that “so and so dropped dead while he was out on his daily jog…I don't get it, he was healthy as a horse!” …well obviously not if he dropped dead. There were OBVIOUSLY other as-yet unknown health problems.

Good information is only good if it's producing profits for you.

You'll still have conflicts between what is considered “the best” information, but that's OK. Two perfectly rational people can have a different view of what the value of a company is worth based on their knowledge and experience.

This leads to different skill levels of investors and traders, which will lead to inefficiencies depending on your skill at determining what the information really means in regards to the value of a given company.

You have to keep in mind that there are a lot of ways that the price of a stock can become mis-priced, which represents inefficiency in the market. This is just one example:

You have multitude of individuals who are not as good as the expert traders buying and selling stocks. They're not even really concerned with making 100% annual returns. They are just doing what some talking head on T.V. told them to do.

For example, let's say you have mom and pop. And mom and pop get paid every Friday, and every payday they decide to put a portion of their money into “xyz stock” or mutual fund.

They've been doing this for a while now, and so have 2 million other mom and pops. This might cause a small pattern to develop in the markets where stock prices move according to the buying /selling done by all those mom and pops on Friday.

It's a small anomaly, but it causes a noticeable change in the financial markets and a *temporary* mis-pricing of certain equities.

The best traders out there then pick up on these developing trends to wipe out the anomaly. In this way, they are setting more accurate prices and making the market more efficient.

If a trader comes along with better information, they set even more accurate prices by trading on that information. They're not there to save the manatees, of course, they are doing this with the primary goal of maximizing profits to themselves or their firm. The effect is that the best information available is reflected in any given stock's price (notice I said “best” not “all”) thus making the market as efficient as possible.

For passive investors, it means that they don't have to worry about a lot of active trading because someone else is already doing that, and the prices of the underlying equities in those index mutual funds is going to be very accurate at any given point in time.

Dave

Thanks for the great comment. You definitely bring up a valid point.

The long term success of Index Funds rests on the premise that there will still be dollars invested in individual assets directly outside of the world of Index Funds. If all investable dollars in the world were Indexed you are right, it would cause quite a problem. However an everybody indexing scenario is highly improbable because trader and investors alike will surely take advantage off the of arbitrageur opportunity or in other words the value / price discrepancy opportunity created from the mass herding into Indexed assets and this would most likely bring back some form of market equilibrium.

Furthermore it really isn't worth worrying about the world indexing. The total amount of invested dollars that are Indexed pales in comparison to total invested dollars. You also have to remember that even the total amount of invested dollars in Index funds, is in a wide variety of assets and asset classes. Not everyone who Indexes buys a Total Stock Market Index Funds or a S&P 500 Index Fund.

The thoughts that Active Traders keep the market efficient is total bullshit. I may be wrong, but I would love to see some research on this assumption.

I'm going to leave it there for tonight. Thanks for the great comment!

Cheers.

Ethan

I agree. I dislike managed mutual funds with a passion. But there's more to it than that. Index investing does work, but you are still relying on other people to make that strategy work – namely the active traders that buy and sell stock in order to make the market efficient enough for you to just sit back and take advantage of the information as it comes to the market.

I think you would be terribly disappointed if literally EVERYONE adopted this strategy. There would be no one setting the prices and your index fund would be worthless…you would have the exact same problem that you are ascribing to actively managed funds.

In short, index investing works as long as a *minority* of investors are using the strategy. The “myth” as it were of the EMH is that information comes to the market instantaneously (or too quickly for anyone to capitalize on it).

The truth is that nothing happens that quickly. You wouldn't have successful traders beating the market every day on their own…and you definitely wouldn't have Peter Lynches and Warren Buffets.

While I don't see anything wrong per se with passive investing, just don't forget who butters your bread )

Cheers.

Ethan

Cheers.

Ethan

In regards to shorting oil and short etf's you have some valid points. However I'm going to have to disagree with you. Shorting oil and using inverse short etf's is a game plan that would not increase the value proposition of mututal funds. Although these strategies may prove profitable if done on your own, which in itself would require lots of time and energy on your part, it most likely they would not prove profitable to the fund owners of mutual funds because in turn a mutual fund that employed these strategies would charge higher expense ratios, more like a hedge fund.

In fact you have described strategies used and marketed by hedge funds and as we all know, the default expense structure for a hedge fund is 2/20. Meaning they get 2% of the asset base in fees no matter if they make or loose money, and then when they do make money they keep 20% of the profits… the clincher is the that taken as a whole hedge funds underperform the S&P 500… ouch

I can't imagine hedge funds clothed in mutual fund skin would be any different.

Thanks for chiming in Ray. As I said at the beginning you definitely bring up some valid points.

Cheers.

Ethan

In regards to shorting oil and short etf's you have some valid points. However I'm going to have to disagree with you. Shorting oil and using inverse short etf's is a game plan that would not increase the value proposition of mututal funds. Although these strategies may prove profitable if done on your own, which in itself would require lots of time and energy on your part, it most likely they would not prove profitable to the fund owners of mutual funds because in turn a mutual fund that employed these strategies would charge higher expense ratios, more like a hedge fund.

In fact you have described strategies used and marketed by hedge funds and as we all know, the default expense structure for a hedge fund is 2/20. Meaning they get 2% of the asset base in fees no matter if they make or loose money, and then when they do make money they keep 20% of the profits… the clincher is the that taken as a whole hedge funds underperform the S&P 500… ouch

I can't imagine hedge funds clothed in mutual fund skin would be any different.

Thanks for chiming in Ray. As I said at the beginning you definitely bring up some valid points.

Cheers.

Ethan