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B. Venkatesh

IN THE past six months, active funds have provided higher returns than index funds. Yet, those who believe in efficient markets state that index funds are a better investment in the long run. Why?

Collectively, all investors earn the market return. This follows from an argument that outperforming the market is a zero-sum game.

Suppose there are only two investors in the market. A zero-sum game means that if one investor generates 2 per cent more than the market, the other investor generates 2 per cent less.

Now, the market return is essentially the index return. It, therefore, follows that half the investors perform better than the index, while the other half under-perform.

Of course, you will want to invest in a fund that performs better than the market. The problem, however, is that which fund is likely to outperform the market is not known.

We generally assume that if a portfolio manager does well in the previous year, he/she will do well the next year too. This need not be the case if one assumes efficient markets.

In such a market, stock prices reflect all available information. So, changes in stock prices are primarily due to arrival of new information. Since arrival of new information is random, the change in stock prices is also random. So, portfolio managers may not continue their winning streak for all time to come.

Of course, all of us may not agree that stock prices are always random. Ask any technical analyst, and he/she will swear that there is always a pattern to stock price movements.

Even then, an index fund is the preferred choice for some. The reason: Portfolio management expenses are low for index funds than for active funds.

The choice between index and active funds depends finally on your risk appetite.

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