Index Funds & Efficient Markets

When Index Funds Make the Most (and Least) Sense

Learn how EMH can make you a better investor. Getty Images

If you like the idea of investing in index funds but still want to tweak performance or find a wise but competitive edge as an investor, there is an investment strategy for you.

Index Funds Work Best for Large-Cap Stocks

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.

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--the best of both worlds, if you will.

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 is on large-capitalization stocks of companies, such as Wal-Mart, Apple and Pfizer. But what about small-cap stocks and foreign stocks?

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.

This also increases expenses, which makes it even more difficult to compete with the low-cost index 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.

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!
