Passive investing is a prevalent feature of the current bull market. According to Morningstar, investors pulled $207 billion out of active funds and placed $220 billion into passive instruments, such as index funds and exchange traded funds (ETFs). This trend has been driven, in large part, by the collective inability of actively managed mutual funds to beat their passive benchmarks.

Investing in an index fund is a perfectly sensible, even desirable, strategy for the average investor. Many wealth management firms have arisen which fully promote indexing strategies for their clients. The principals of these firms often refer to their indexing strategies as “evidence-based investing”. These advisers go as a far as to claim that the evidence irrefutably proves that no method of active stock selection can yield above-average results. This claim to evidence raises at least two questions. First, what is the evidence to which the indexers are referring? Second, is the evidence as irrefutable as the indexers suggest?

The intellectual foundation of indexing is the efficient markets hypothesis (EMH), a theory which has been a staple of business school education for decades. The EMH states that all available information is instantly and appropriately incorporated into a stock’s price. Presumably, the academic work behind the EMH is the evidence to which the indexers are referring.

The EMH in its modern form was first advanced by Eugene Fama, a professor at the University of Chicago, in a 1965 paper “The Behavior of Stock Market Prices”. This paper concluded that stock prices followed a “random walk”, i.e., stock prices are independent of past movements. The paper was well-received by the economics community, and Fama and other researchers broadened the theory to suggest that all information was incorporated into stock prices. By the 1970’s, the EMH in its narrowest form had reached its peak.

By the 1980’s, however, a new field called behavioral economics began to emerge. The work generated from this field brought the most extreme conclusions of the EMH into doubt. For example, Robert Shiller wrote a 1980 paper in the American Economic Review in which he observed that stock price volatility was significantly greater than could be justified by changing fundamental factors (in this case, dividends). Similarly, in a paper in the Journal of Finance Richard Thaler and Werner De Bondt concluded that stock traders overreact to information, such that stocks with exceptionally large declines (low price-to-earnings ratios) tended to outperform stocks with overly large price increases (high price-to-earnings ratios). Even subsequent research by Fama and Kenneth French supported the observation that “value” stocks tended to outperform.

While the body of pro EMH literature is vast, so is the literature supporting the behavioral view of finance. As if to highlight the ongoing debate behind the EMH, the 2013 Nobel Prize in Economics was shared (with Lars Peter Hansen) by Eugene Fama and Robert Shiller. Regardless of how one views market efficiency, they should at least be familiar with the evidence on both sides of the debate.