If you read my columns regularly, you'll note I have some phrases I use repeatedly. One which does not belong to me, but I borrow often is, "In theory, theory and practice are the same. In practice, they are not." This is a perfect introduction to explain why indexation strategies work well in spite of market inefficiency.
The market efficiency debate is born of academia, but is widely discussed by investors. In a nutshell, if a market was completely efficient, then the prices of all securities would always be correct, taking into account all known information, and all unknown information, including insider information. If prices were always correct, what would be the point of taking bets against those prices?
The quick answer is that if those assumptions were true, there would be no point in betting against the prices of any security or the market. This is part of the reason for the genesis of the first index funds and passive investment strategies.
Since the amount of money invested in active strategies is much greater than the amount of money invested in passive strategies, it's clear that most people don't believe in complete market efficiency. Active investors believe securities are mispriced. If they believe a stock is priced too low, they buy it. If they believe a stock is overpriced, they sell it off, or short it.
If you put all the active bets against the index into one room, collectively you are left with the index. If someone is overweight a certain stock relative to the index weight, then there must be someone who is underweight that same stock relative to the index weight.
If you then add up all the active bets, the overall return is going to look like the index return, less fees. Since the fees associated with the passive index strategy (with no manager and research team to pay for) are lower than the fees associated with active investing, the average passively invested dollar must necessarily beat the average actively invested dollar.
The above logic applies irrespective of the efficiency of a given market. This does not preclude index-beating performance by an investment strategy or fund. Clearly there are winners and losers. It simply means that not everyone can be above average.
So in theory, if a market is efficient, then an indexing approach is the most prudent strategy. But in practice, markets are not completely efficient. How you choose to invest will depend upon who you side with in the debate.
And remember, there's no law that says you can only pick one side. A far greater determinant of success is the ability to stick with a prudent strategy, be it passive or active.
Preet Banerjee is a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.