Deficient Markets Hypothesis
Posted on June 24, 2009 by Richard Beddard
Filed Under Markets |
In theory:
As dead as a parrot
In his latest note, Soc Gen Analyst James Montier, compares the efficient markets hypothesis (EMH) to Monty Python’s dead parrot.
No matter how much you point out that it is dead, the believers just respond that it is simply resting!
Montier’s often pronounced EMH dead. In fact, he’s getting so frustrated he’s beginning to rant like John Cleese.
The shopkeeper refusing to accept EMH’s demise could be arch-exponent Burton Malkiel whose book, A Random Walk Down Wall Street is an investment classic now in its ninth (2007) edition. Malkiel, a professor of economics, and investor says the premise of his first edition, that:
…the market prices stocks so efficiently that a blindfolded chimpanzee throwing darts at the Wall Street Journal can select a portfolio that performs as well as those managed by the experts…
…has held up pretty well:
More than two-thirds of professional portfolio managers have been outperformed by the unmanaged S&P 500 Index. Nevertheless, there are still both academics and practitioners who doubt the validity of the theory.
Those of us who try and beat the market have a case to answer:
First, there’s an elegant and simple theory that states that if people behave rationally then they will pay more for good investments, right up until the point they are no better value than lower quality but cheaper investments. In such a world, the price would always be right and there would be no reason to invest in one company, over another. Catch-22.
Second, most investors who try to beat the market, fail.
I can almost hear Montier screaming. As I said last week, an alternative hypothesis, beloved of value investors and the emerging field of behavioural finance, is that investors aren’t rational. They herd, finding safety in numbers and bull markets, right up until they go off the edge of the cliff together in bear markets.
If you invest in the market through index trackers as Malkiel advocates, you’re tied into that daft behaviour. But judging by their records, the professional investors Malkiel talks about, make even dafter choices.
How can that be? Another academic, Mark Rubenstein, described the sub-par performance of professionally managed funds as:
…a nuclear bomb against their [the behaviouralists’] puny sticks… [they] have nothing in their arsenal to match it.
Montier says this observation is flawed because US institutional investors managed about 70% of the whole US stockmarket in 2007 and the composition of their portfolios mirror the whole market. Hence they’re doomed, as a group, to be average, or below average after they take their fees. In other words, they’re not as independent of the market as they’d like us to think they are.
Why should that be? Career risk, he says, explains the herding. To bet against the market is to stand out from the crowd. When, for a while, you do worse than the market, you stand out for the wrong reason. Clients withdraw their money and you risk going out of business before you demonstrate you can beat the market. As John Maynard Keynes said:
…it is better for reputation to fail conventionally than to succeed unconventionally
So professional investors are very rational. They do what it takes to keep their jobs, even if those actions don’t serve the long-term interests of their irrational clients, pension fund trustees, insurance companies, financial advisers, and, well, people.
If EMH is dying, Montier is doing his best to ease it into the coffin. He quotes a survey showing 67% of chartered financial analysts thought the marked failed to behave rationally:
When a journalist asked me what I thought of this, I simply said “About bloody time”. However, 76% said that behavioural finance wasn’t yet sufficiently robust to replace modern portfolio theory (MPT) as the basis of investment thought. This is, of course, utter nonsense. Successful investors existed long before EMH and MPT. Indeed, the vast majority of successful long-term investors are value investors who reject pretty much all the precepts of EMH and MPT.
But does it matter, beyond, the arcane arguments of academics and investors? Well, yes. If markets are irrational, then it’s adherents of EMH that have a case to answer, says Philip Coggan, The Economist’s Buttonwood columnist:
From this [the assumption that market prices are always right] developed the idea that bubbles cannot exist and thus that central banks should do nothing about rising asset prices. That belief may well have been dangerous. In particular, returns are not “normal”, in the sense of following a bell curve distribution. They are plagued by fat tails or extreme outcomes; failing to allow for these outcomes contributed to the recent crisis.
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If the stockmarket was efficient, then computer algorithms would be better at trading than humans, says quantitative trading system designer Joshua Holden.
Seth Klarman explains the market’s short-termism. Fund managers who focus on long-term wealth creation should be rewarded but it’s actually those that do well in the short-term that get assets.
The Economist reviews “The Myth of the Rational Market” by Justin Fox.
Whatever next? Hedge fund managers are plugging their platforms into Twitter.
In practice:
The price isn’t right
Strictly not for EMH acolytes: The stockmarket is still looking cheap, although it’s not in outright bargain territory as it was, briefly, in March…
…Which may explain the glut of apparently cheap and financially sound companies. All of the following have prices less than twenty times average earnings and score six or more out of nine according to Piotroski’s F_Score:
The date as always is from two commendable services Sharelockholmes.com and Sharescope.
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18 Responses to “Deficient Markets Hypothesis”
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I have (of course!) written a response to this: http://moneyterms.co.uk/blog/200906-active-investors
I link to an explanation by French and Fama, which I found via the Empirical Investor Blog post you recently linked to.
Thanks Graeme! It’s just like old times
I agree with your post except perhaps the implication I read into it that because active investing is a negative-sum game, you shouldn’t play it. I shall elaborate, of course, in a future post, but the gist will be that individual investors can win the game.
The article you link to is fascinating, and as you say, perfectly obvious.
Not exactly you should not play it: I would say most investors would be better off not paying.
I was also thinking of blogging on why opportunities to out perform do exist.
There’s a real danger we might end up agreeing on this and therefore of me pre-empting a future blog post! From a personal point of view I think I am better than average in my own back yard, UK, especially smaller companies. However half my portfolio is in the rest of the world, and much as I’d love to study all those markets (I really would) it’s just beyond me. How do I invest in those markets? At the moment it’s one global (ex UK) index tracker. I have three reasons for chosing a passive fund. First, I don’t know how to identify fund managers that will be successful in future and 2. I think it is harder for managers of large funds to beat the market anyway (because to beat it they have to be different to it, when often they end up mimicking it) and 3. passive charges tend to be lower. There you are. That’s my blog plan in a nutshell. I’ve given the game away. Now I’ll just have to put some meat on it
Please do blog on why opportunities to outperform exist!
Hi Richard,
I personally think that EMT is credible if you believe that this is not measuring all the information available but is measuring the common consensus of the interpretation of the information.
For example, the common consensus of the information right now, today (25 Jun2009), is that the S & P 500 is fairly valued which is why it is range bound. In one month’s time, after being in earnings seasons for a few weeks, everyone will suddenly realise how stupid they were when a new picture starts to emerge which will be one of
1) Earnings significantly higher
2) Earnings significantly lower
3) Earnings flat
No doubt, somewhere in all the existing information, the answer is already apparent but 99% of people have not spotted it and the other 1% are keeping quiet, as they are going to make lots of money.
It seems to me that the fund manager who wants to be contrarian needs to put 80% of his portfolio into an index tracker and then the remainder can be used for personal stock picks. Most fund managers survive a period of underperformance so long as it is not too excessive. If a value fund manager is any good then they should be able to translate that 20% of stock picks into an over-performance of 3% to 5% in the long term, which is good by anyone’s books.
I think the possible counter-example to the Fama/French argument is to look at the index rebalancing involved with passive indexes.
If active investors can anticipate correctly the new weightings of the passive index then they can buy it ahead of time and profit at the expense of the passive investor.
I know that historically this has been proven not to happen but I am just saying that in theory active investors may be able to steal from their passive cousins and make a net gain
Another scenario where active investors may be able to profit from passive investors is when meddling governments start printing money like there is no tomorrow and give it to certain sectors at the expense of other sectors!
Hi Robin,
I think EMH (which I can’t help reading as emergency medical hologogram - from Star Trek) advocates would say that any advantage like that is arbitraged away very rapidly, as soon as it becomes apparent which companies are likely to be demoted/promoted and which sectors are likely to benefit from govt largesse or suffer from a lack of it.
I don’t think forecasting (earnings/index participants/the effects of government policy) gives investors an edge… the market is efficient in that the average of all our guesses is probably the best guess and if you make a better prediction it’s luck, not skill.
Better not to forecast, but to focus on companies/sectors that the forecasters neglect because they’re not fashionable, there’s no big story pushing up share prices because the future often turns out unexpectedly and they’re more likely to surprise us pleasently.
That’s how I think active investors can pick the pockets of passive investors (which gives me a good headline for a future blog! - thanks
)
When will the FSA consider that retail investment funds which rely on models that assume Gaussian distribution are in breach of one or more of the ‘high level principles’ http://fsahandbook.info/FSA/html/handbook/PRIN/2/1
Robin, active investors cannot accurately guess at the rebalancing well enough. Index trackers hold a representative portfolio, not every stock in the index.
If they are tracking a big cap index, they are least likely to hold new entrants that are usually among the smallest companies in the index. They may buy those companies at some point, especially if the market cap keeps growing, but not all of them will do so at the same time, so the opportunity is not really there.
Hi Graham,
Thanks for your clarification on indexes.
I think the point I was mainly trying to make is that the argument that active investors must make a net loss is mathematically flawed because it assumes that they can only take money from each other. The argument does not allow for the possibility that they could also take money from the passive investors, and therefore lower the passive investor net gains over time.
Do you not feel this is a possibility?
While I understand that an active investor who restricts themselves to investing in the companies of a single index must ultimately lose out to that index, I think it has been proven that an investor, who uses even a simple rebalancing strategy across several indexes, can outperform the underlying indexes they are investing from over time.
What do you think?
Yes, that is true, but it is not altogether a fair comparison. If an investor is entirely passive they would by an index that covered all investments available to them, or a capialisation weighted combination of such investments.
If they passive investor is picking a particular index, and therefore is performing an asset allocation. It is this active choice by the passive investor that gives the active investors a chance to out-perform.
Incidentally, most out-performance comes from asset allocation.
“Incidentally, most out-performance comes from asset allocation.”
That’s one that really gets my goat! Value investors picking stocks are by definition also allocating their capital to assets that are undervalued. Stock picking is an act of asset allocation. I think in focusing on indexes and averages and asset classes people miss what’s happening within them.
I agree wit you, Richard. The way I look at it, is that a bottom up approach rolls into one process what you would do in several steps with a top down approach.
That is one reason I dislike doing recommendations per sector, it pressures one to pick something to buy, even if the whole sector is over-valued;
Hi Richard and Graham,
After thinking about this a lot recently, I have concluded that the only time when active investors can steal from passive investors is when the passive investors are forced sellers in a market downturn. At this point the active investor can sell their better performing assets and buy the passive investors under-performing assets. This will allow the active investor to take some of the market share from the passive investors.
The key strategy needed by the active investor is a method to recognise when you are buying the assets at a discount and the determination to hold those assets until they realise their true value (hmmm I wonder where I have heard that idea before :-))
Regarding the ‘perfect global index’ idea that Graham mentions, I think that this is not a realistic concept. While I accept that the total of passive investors will perform on average, many pockets of them will be under-performing and also be forced sellers. Active investors should be able to take advantage of this.
Hi Robin, I thing I agree, but just explain to me why passive investors are only forced sellers in a market downturn? Surely they are forced buyers and forced sellers all the time according to the rules that define the construction of the index. I agree they’re not really passive, they’ve just predetermined their active trading strategy and are ‘passively’ following it, but I think whatever the state of the market there is the opportunity for active investors to take money from them, and other active investors.
Hi Richard, I was not clear enough. Passive investors can be forced sellers at any time. However the only time that an active investor can steal market share from them is when the passive investor has to sell during a downturn in their specific combination of indexes.
As an aside, I think you or Graeme once had an article (or link) which talked about a potential flaw with indexes built using market cap. Specifically this was flawed because when you rebalance the index each quarter, you tend to sell your worst holdings (possibly at a loss) and then buy some new overvalued holdings.
Hi chaps, I’m just reading Seth Klarman’s ‘Margin of Safety’, which after Security Analysis might be Value Investing’s New Testament. Obviously he’s no fan of indexing (he believed in the 90’s that it was just another Wall St fad). He quotes Buffett, who says “in any sort of a contest - financial, mental, or physical - it’s an enormous advantage to have opponents who have been taught that it’s useless to even try.”
Klarman’s substantive point is that indexing is self-reinforcing as investors are forced to buy companies entering the index, increasing the value of the index, which encourages more indexing. This means companies in the indexes being tracked are overvalued. Someday the relationship will break down, the market trend will not be attractive, which encourage less indexing and encourages more price falls. It sounds like a recipe for instability - or inefficient markets, which increases the opportunities for the value investor. Or as Robin says, for the active investor to steal from the passive investor. I think we’re in that situation now.
This is the problem with conventional models. They’re very plausable at a basic level but they fail to account for the uninteded consequences.
Richard, I am not convinced by that. Most of the money that goes into trackers would go into companies in that index anyway. The FTSE100 is something like 80% of UK market cap, and the conservative investors who buy trackers would likely to overweight, rather than underweight, the index if they were active investors.
Many index trackers track the all share which covers even more of the market.
If you are looking for shares you can be sure the trackers will avoid, two areas that come to mind are:
1) small caps
2) smaller merging markets
There is evidence that both do out-perform in the long term, although I do not think the reasons have anything to do with being ignored by index trackers (unless you count closet trackers in the latter case).