In layman's terms, what is the Efficient Market Hypothesis?

The Efficient Market Hypothesis says that market prices are fair: they fully reflect all available information. This does not mean that prices are perfect; some prices may be too high and some too low, but there is no reliable way to tell. In an efficient market, investors cannot expect to earn above-average profits without assuming above-average risks. Market efficiency does not suggest that investors can't "win." Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance.

Source: Dimensional Fund Advisors

Isn't the success of indexing in recent years mostly due to a "self-fulfilling prophecy"? Index funds appear to push up prices of a handful of big company stocks simply because they're included in the S&P 500 index.

Some critics of indexing assert that mechanical buying from index funds creates a "self-reinforcing trend" in a handful of large company stocks and that their price behavior is dictated by cash inflows to index managers, not fundamental business conditions at the underlying companies.

Evidence to support this assertion is difficult to find. Dimensional believes a more plausible explanation of pricing suggests it is the active money managers who dictate prices to indexers, not the other way around. As an example, an analysis of trading activity in General Electric Corp. stock (the largest component of the S&P 500 index) found that programmed buying from index funds in January 1997 accounted for approximately 1.3% of total GE monthly trading volume (Strategic Insight Mutual Fund Overview, February 1997). The notion that 1.3% of trading attributable to passive investors possessing no useful information determines the price-discovery process for the remaining 98.7% of market participants is far-fetched.

Advocates of the "self-fulfilling" viewpoint must also confront a wide disparity in performance of individual issues. If the behavior of large company stocks is primarily attributable to passive investors buying without regard to fundamental developments, it is difficult to explain why Coca-Cola shares appreciated only 1.3% in 1998 while Wal-Mart Stores soared 108.0% (Standard & Poor's "Stock Guide," January 1999).

Source: Dimensional Fund Advisors

If everyone followed an indexing strategy, would markets still be efficient?

This question has come up repeatedly ever since indexed strategies first appeared in the mid 1970s. Critics of indexing assert that markets would be less efficient if all investors adopted a market-fund investment approach. One can accept this theoretical viewpoint and still embrace indexing with enthusiasm.

If the adoption of indexed strategies became so pervasive that market efficiency were impaired, Dimensional believes it would be a self-correcting process. Mispriced securities would create opportunities for investors to earn profits in excess of their research costs, and their activity would drive prices back to equilibrium levels. We will never know how much information and liquidity are required for an efficient market. Markets for consumer durables such as homes or autos appear to be at least reasonably efficient, despite very poor liquidity, high search costs, and the absence of perfectly fungible assets. This behavior suggests a shift to passive investing would have to be very pronounced to have any effect on market efficiency.

Even if all professional investment managers adopted a passive approach, other market participants would continue to provide price-setting information. Sources of such information could include corporate stock buybacks, acquisitions, and the investment activities of officers, employees, competitors, and suppliers.

Despite the impressive commercial success of indexed investing strategies over the last twenty-five years, they still represent only a fraction of total stock market wealth. The assets of all index mutual funds managed by indexing giant Vanguard Group were approximately $176 billion as of December 31, 2001, or roughly 1% of the nation's total stock market value.

Source: Dimensional Fund Advisors

Can any single industry—for example, the high-tech sector—assure investors above-average returns?

Detailed research into the sources of investment returns (Fama, Eugene F. and Kenneth R. French. "Industry Costs of Equity." Journal of Financial Economics 43 (1997), 153-93.) concludes that industries, or companies' products, are not a factor in expected stock returns. Industry effects can influence prices, but in a seemingly random, short-term way that can be mitigated in a diversified strategy. Therefore, industry effects, though they pose risks that are worth taking into account, are not a primary variable on which to sort securities for investment purposes.

Firms developing new technologies have no assurance of earning above-average long-run profits. The competitive forces in a free market work constantly to disperse the benefits of innovation throughout the economy. The retailer using new high-speed computers to cut inventory costs, for example, may reap greater economic rewards than the company who developed them. And if competition pressures the retailer to pass the resulting savings along in the form of lower prices, the ultimate beneficiary is the consumer. Even if one could correctly predict technological trends, identifying the winners from an investment standpoint becomes an elusive exercise.

Consider the birth of the personal computer industry in the early 1980s and its subsequent explosive growth. Industry pioneers IBM and Apple Computer were responsible for many innovations, yet shares of both firms have lagged the broad stock market: total return for the 20-year period ending December 2001 was 333% for Apple Computer, 1360% for IBM, and 1606% for the S&P 500 index (Center for Research in Security Prices, University of Chicago; Ibbotson Associates).

Source: Dimensional Fund Advisors

What is CRSP?

CRSP ("crisp") is an acronym for the Center for Research in Security Prices at the University of Chicago. Established in 1960 with a grant from Merrill Lynch & Co., the center undertook a massive data-gathering project to answer the question "how have stocks performed over the long term?" Under the direction of James Lorie, Ph.D., a professor of business administration, and Lawrence Fisher, associate professor of finance, a database of both price and dividend information was compiled for all common stocks listed on the NYSE beginning in 1926. Over two million bits of information were entered onto magnetic tape, and the commercial computers then becoming available calculated total returns. The results were published in a landmark article in the Journal of Business in January 1964. The center continues to add data on a regular basis, and with a substantial grant from Dimensional Fund Advisors in 1984, added data from NASDAQ markets starting in January 1972. The CRSP data files have been an essential tool in the study of capital markets by an entire generation of financial economists.

Source: Dimensional Fund Advisors