The Models Are Broken—But Indexing Still Works

If you’ve researched the theoretical foundations of index investing, you’ve no doubt come across Modern Portfolio Theory and the Efficient Markets Hypothesis. And if you read the commentaries of active money managers and the financial media, you’ve probably seen countless articles that dismiss both as obsolete. Modern Portfolio Theory is declared dead after every market crash, and all stock pickers, almost by definition, believe markets are not really efficient. Many of these critics think passive investing is folly—only the warm embrace of active management can protect you and your portfolio.

In his provocative book, Risk, Financial Markets & You, the Winnipeg-based financial advisor Alan Fustey adds his own criticisms of these two decades-old models. But his conclusion is surprising. When I interviewed him recently, I asked what investors should do if these models were broken. “Well, the first thing you do,” Fustey replied, “is you index.”

The background

Before going further, let’s review these two landmark financial theories, both of which revolutionized investing. Modern portfolio theory was devised in 1952 by Harry Markowitz, who later shared a Nobel Prize for his contribution. Markowitz showed that by combining risky assets that have less than perfect correlation, you can create a portfolio that has lower risk and a higher expected return than its individual components. Index investors understand this as the “free lunch” offered by diversification.

The efficient markets hypothesis was formulated by Eugene Fama in a 1970 paper. It suggests that security prices reflect all public information, and therefore analysis of individual companies does not allow investors to identify “mispriced” stocks. (Occasional mispricings probably exist, but they cannot be reliably exploited.) In an efficient market, buying an index fund is the best way to get market exposure at the lowest possible cost.

‘You’ve got to have a better alternative’

These two ideas are among the pillars of the Couch Potato strategy. But as Fustey explains in Chapter 4 of his book, both have some shortcomings. For example, he says, MPT presumes that asset class correlations remain constant, and that market returns follow a normal distribution (represented by a bell curve). We know neither of these assumptions is valid. He also points out that it is possible for some  participants to have an informational advantage, so capital markets are not truly efficient.

But if you think Fustey is building a case against passive investing, think again: he argues that indexing still offers investors their best chance of success. “It comes down to this,” he told me. “If you’re going to throw out these ideas, then you’ve got to have a better alternative. If you reject the efficient markets hypothesis, you’re saying that you have the ability to get superior information, and that you can make money from that knowledge. But that flies in the face of reality. Someone is always going to have better information than someone else, but are you going to be able to profit from that on an after-fee basis? I don’t think so—and the history of active management proves that.”

Book giveaway

Alan Fustey is a CFA and a portfolio manager at Index Wealth Management, a Winnipeg firm that also has offices in Calgary and Vancouver. I recently added the firm’s three offices to my Find an Advisor directory.

Alan sent along two copies Risk, Financial Markets & You to offer to readers who are interested in learning more. Leave a comment below to be entered in the draw for the books. Contest closes at midnight EST on Wednesday, May 2. I will announce the winners in Thursday’s post.

Speaking of contests, a big thanks to everyone who requested a ticket to PWL Capital’s event featuring Carl Richards, author of The Behaviour Gap. The answer to the skill testing question was Buckingham Asset Management (BAM Advisor Services was also acceptable). Winners will be notified by email.