The efficient market hypothesis is a funny thing. It’s one of those touchpoints that demonstrates how academic research becomes quickly misunderstood when it trickles down to the greater populace.

Originally designed as a construct to make theoretical models easier to perform (reminiscent of the “first let’s imagine a spherical cow” jokes about economists and physicists), the EMH has since become a rallying cry for retail investors on the march to low-cost passive index funds. And while those funds are useful for most long-term investors looking to retire a long time in the future, that is a small corner of the financial industry, and indexing has little value beyond it. What’s more, the reason why indexing works for them is not because the EMH is right, but because of other more complicated issues that are hard to explain.

One of the arguments of the proponents of the EMH, despite their misunderstanding of the theory, is that you can’t beat the index. This assumes the index itself is a fixed rules-based benchmark that does not change by time and is not actively managed by fallible human beings.

News from late last week disproves how fallacious that belief is. S&P Dow Jones Indices announced several changes to their indices, with popular and high-flying stocks Advanced Micro Devices (AMD) and Raymond James Financial (RJF) joining the S&P 500. This in itself isn’t the really big news. At the same time, S&P has changed the definition of their indices. Now an S&P 500 stock is one with a market cap of $6.1 billion or greater, versus the $5.3 billion or greater requirement in the past.

What drives a higher market cap? Higher stock prices. By increasing the definition of the S&P 500 index, one could argue S&P is chasing top performers, making the same mistake as those who buy momo stocks at the top of their runs.

Of course, indices are fallible and imperfect. They are not designed to outperform the market—they are designed to be an accurate assessment of the market itself. They were never designed to be investment tools; they were designed to be analytical tools used to analyze and understand the market itself.

It’s also worth remembering that the S&P 500 has changed the definition of the index several times—including the size of the index itself—throughout its history. Because, of course, the market changes and so we need new tools to study the new market we are facing.

And these changes are made according to the judgment and market analysis of S&P’s analysts. The index that all passive indexing is based on is, by definition, actively managed.

The irony and the paradox of this in light of the gospel of Bogleheads, Vanguard fans, and the passive indexing fee-obsessed masses is an interesting one to contemplate.

Share This