Markets are efficient, but pricing errors can occur. The Efficient Markets Hypothesis states:
•Current prices incorporate all available information and expectations.
•Current prices are the best approximation of intrinsic value.
•Price changes are due to unforeseen events.
•“Mispricings” can occur but not in predictable patterns that can lead to consistent outperformance.
The Hypothesis Does not State:
•All investors are rational.
•Prices are always right.
•Prices should be stable.
•Professional money managers can’t earn higher than market returns.
Indexers are price-takers
Indexes are forced buyers and sellers. As such, they are forced to take the market price on any given day.
Hedge funds and other investors take advantage of this aspect of indexing by recognizing which securities will be added to an index. After (or even before) the announcement of a stock being added to an index, the price generally rises as intelligent investors know the large index mutual funds will have to buy the stock from them in the future (on the effective date.
By bidding up the price they capitalize on index fund investors rigid requirements to buy a stock.
An index fund is always off
Over time, securities migrate from one category to another. Yet, an index takes time to catch-up and change.
An index can be materially different months after reconstituting. At any given time your fund will drift from the index.
1) Efficient Markets. Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25, no. 2 (May 1970): 383-417. Eugene F. Fama, “Foundations of Finance,” Journal of Finance 32, no. 3 (June 1977): 961-64.
2) Indexers are price-takers.S&P 500 data source: Anthony Lynch and Richard Mendenhall, “New Evidence on Stock Price Effects Associated with Changes in the S&P 500 Index,” Journal of Business 70, no. 3 (July 1997): 351-83. MSCI EAFE Index data source: Rajesh Chakrabarti, Wei Huang, Narayanan Jayaraman, and Jinsoo Lee, “Price and Volume Effects of Changes in MSCI Indices: Nature and Causes,” Journal of Banking and Finance 29, no. 5 (May 2005): 1237-64. For illustrative purposes only. Past performance is not a guarantee of future results.
3) An index fund is always off. Investing involves risks such as fluctuating value and potential loss of principal value. There is no guarantee strategies will be successful.