Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship

CHAPTER 7

Efficient Markets and Mutual Fund Investing The Advantages of Index Funds

BURTON G. MALKIEL, Ph.D. Chemical Bank Chairman’s Professor of Economics at Princeton University

 

 

 

This chapter discusses the strategies for investment in mutual funds that are consistent with a belief that securities markets in the United States and the rest of the developed world are reasonably efficient. We shall see that the optimal strategy in such cases is to concentrate one’s portfolio in low-cost indexed mutual funds. Equity index funds simply buy and hold all the stocks in a very broad stock market index and do not trade from security to security in an attempt to achieve returns that exceed those of the market as a whole. Portfolio turnover is required only when new companies are added to the index or existing firms are removed because of merger, bankruptcy, privatization, and the like.

The efficient market hypothesis is often cited as the intellectual justification for indexing. We shall see, however, that markets need not be efficient to justify the use of index funds. Index funds tend to outperform the vast majority of actively managed funds even if markets fail to live up to the requirements of efficiency.

In this chapter, I make the case that index funds should constitute the core of every investment portfolio. I also describe what has come to be known as the core-satellite strategy, where index funds are used as the core of the portfolio and actively managed mutual funds may be ...