The efficient market hypothesis (EMH) is touted by many retirement advisors and financial planners as an orthodoxy that tells investors that, whatever they do, they should avoid active funds. The reason is simple: the market is too efficient, and whatever outperformance fund managers will get is either attributable to luck (so it won’t last long) or is negated by fees (because the inefficiencies are so small).
And this is entirely true—for the large-cap stock market. The vast majority of active funds will not outperform over the long term because there is so much attention on large-cap stocks that any information inefficiency will not last long enough to result in a fund beating the passive index. And when it comes to mid-cap funds, this axiom also applies very frequently.
That’s where things get a little weird.
Small-cap funds will not outperform over half of the time, but the number of active funds specializing in this group of stocks that does outperform tends to be larger than the same for large-cap and mid-cap funds. And when we move further and further away from large-cap stocks, the number of active funds beating the index tends to rise.
If we move into investment-grade corporate bonds, we start to see a majority of active funds outperforming the index. With preferred stocks, the vast majority of funds outperform the index. High-yield junk bonds? Even more active funds beat the index. As we get into more exotic asset classes such as CLOs, MBSs, and so on, the outperformers reaches 100%.
This should make intrinsic sense. The more complex and opaque an asset class, the more inefficiencies that active funds can take advantage of to beat the index. Bonds and preferred stocks lack the liquidity (and thus constant price discovery as new information is made public) of stocks. In fact, a correlation between an asset class’s liquidity and its efficiency is very consistent.
For financiers, the implication of this observation is significant: if you want to provide value to investors through delivering alpha, you need to go beyond the well-trod world of large-cap stocks and find alternative investments to specialize in and offer market-beating insights. Those that succeed at this game will not only crush the market, but also find a loyal fanbase of investors who appreciate the alpha they deliver.