Indexer? Valuation Still Matters

The relationship between indexing and efficient-market theories is more nuanced than many believe

Samuel Lee 12 October, 2011 | 6:18PM
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Indexing is based on a simple proposition: Net of fees the markets are hard, if not impossible, to beat. The proposition has been tested many times, with supportive results. No surprise then that passive funds' market share has surged to 24% from 11% of all open-end and exchange-traded fund assets over the past decade. But indexing's well-deserved success has coincided with a disturbing abrogation of responsibilities by some investors and advisers. Many believe that they can't or shouldn't estimate expected returns of their investments. They've consigned valuation to the dustbin.

This is wrongheaded, motivated by a view of markets rejected decades ago. The early efficient-market theorists assumed that the market's expected returns, risks, and correlations were constant through time. Almost no financial economist believes this today. The market's expected returns change. And there's heaps of evidence that the market's returns are somewhat predictable over long horizons.

Market Predictability
On an intuitive level, the market must be predictable to some extent. Otherwise, how could investors set prices for stocks versus bonds versus cash? We can also reasonably rule out certain scenarios, such as corporate earnings growing much faster than gross domestic product indefinitely, which would result in corporate earnings eventually taking over the entire economy. That returns are bounded by mean-reverting attributes of the economy points to predictability. Indeed, the evidence is compelling. In the August 2011 issue of The Journal of Finance, University of Chicago professor John Cochrane wrote: ". . . predictability is pervasive across markets. For stocks, bonds, credit spreads, foreign exchange, sovereign debt, and houses, a yield or valuation ratio translates one-for-one to expected excess returns, and does not forecast the cashflow or price change we may have expected." In other words, measures such as dividend/price predict future returns, especially over long horizons. Cochrane is a prominent efficient-markets theorist.

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Samuel Lee  Samuel Lee is an ETF Analyst with Morningstar.

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