likely to generate the differential insight necessary to yield trading profits. Moreover, these techniques are economically feasible only for managers of large port- folios. If you have only $100,000 to invest, even a 1% per year improvement in perfor- mance generates only $1,000 per year, hardly enough to justify herculean efforts. The billion-dollar manager, however, reaps extra income of $10 million annually from the same 1% increment. If small investors are not in a favored position to conduct active portfolio management, what are their choices? The small investor probably is better off investing in mutual funds. By pooling resources in this way, small investors can gain from economies of scale. More difficult decisions remain, though. Can investors be sure that even large mutual funds have the ability or resources to uncover mispriced stocks? Furthermore, will any mis- pricing be sufficiently large to repay the costs entailed in active portfolio management? Proponents of the efficient market hypothesis believe that active management is largely wasted effort and unlikely to justify the expenses incurred. Therefore, they advocate a passive investment strategy that makes no attempt to outsmart the market. A passive strategy aims only at establishing a well-diversified portfolio of securities without at- tempting to find under- or overvalued stocks. Passive management is usually character- ized by a buy-and-hold strategy. Because the efficient market theory indicates that stock prices are at fair levels, given all available information, it makes no sense to buy and sell securities frequently, which generates large brokerage fees without increasing expected performance. One common strategy for passive management is to create an index fund, which is a fund designed to replicate the performance of a broad-based index of stocks. For example, in 1976 the Vanguard Group of mutual funds introduced a mutual fund called the Index 500 Portfolio, which holds stocks in direct proportion to their weight in the Standard & Poors 500 stock price index. The performance of the Index 500 fund therefore replicates the per- formance of the S&P 500. Investors in this fund obtain broad diversification with relatively low management fees. The fees can be kept to a minimum because Vanguard does not need to pay analysts to assess stock prospects and does not incur transaction costs from high portfolio turnover. Indeed, while the typical annual charge for an actively managed equity fund is more than 1% of assets, Vanguard charges a bit less than .2% for the Index 500 Portfolio. Indexing has grown in appeal considerably since 1976. Vanguards Index 500 Portfolio was the largest mutual fund in 2000 with more than $100 billion in assets. Several other firms have introduced S&P 500 index funds, but Vanguard still dominates the retail market for indexing. Moreover, corporate pension plans now place more than one-fourth of their equity investments in index funds. Including pension funds and mutual funds, more than III. Equilibrium In Capital Markets 12. Market Efficiency The McGraw−Hill Companies, 2001