EMH - The Context for Passive Investing.

Although individual investment managers often claim spectacular returns over a short period, there is a body of evidence (The Efficient Market Hypothesis - EMH) that, over the long term, index tracking funds outperform actively managed funds because fund managers cannot consistently earn the extra return needed to pay their wages. The EMH suggests that the instantaneous value of a company represents the best guess based on the information available at that moment.

New information quickly permeates the market and the company's value will adjust almost instantaneously to reflect this new information. Since noone other than an insider has access to special information, nobody can have a better idea of the value of the company.

The conclusion of the Efficient Market Hypothesis was that by buying all the shares in an index, or a significant sample of them, the investor would stand a good chance of achieving the return on the market - the best realistic return to be consistently available.

Of course followers of Warren Buffett et al would disagree!

To maximise their return, the Efficient Market Investor needs to minimise the costs involved in 'buying the index' and then updating the portfolio to reflect the changing relative weights of shares in the index.

Whereas the larger institutional investor could afford the transaction and maintenance costs of holding whole indexes, at first the only alternative for the smaller private investor was to buy a Unit Trust that tracked the Market. This might charge 1% a year or more in managament fees, eroding the benefits of passive investment.

Then along came ETFs....


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