Does Anyone Actually Believe in Market Efficiency?

This is fascinating. Finance Professor and creator of the Efficient Markets Hypothesis Eugene Fama:

The premise of the Fox book ["The Myth of the Rational Market"] is that our current economic problems are largely due to blind acceptance of the efficient markets hypothesis (EMH)…

The book is fun reading, but its main premise is fantasy. Most investing is done by active managers who don’t believe markets are efficient. For example, despite my taunts of the last 45 years about the poor performance of active managers, about 80% of mutual fund wealth is actively managed. Hedge funds, private equity, and other alternative asset classes, which have attracted big fund inflows in recent years, are built on the proposition that markets are inefficient. The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems. Finally, MBA students who aspire to high paying positions in the financial industry have a tough time finding a job if they accept the EMH.

I continue to believe the EMH is a solid view of the world for almost all practical purposes. But it’s pretty clear I’m in the minority. If the EMH took over the investment world, I missed it.

This gets to something like the Grossman-Stiglitz paradox, which is, if markets reflect all information, where’s the incentive to get the information needed to keep markets efficient? The “keeping” part is key there, since the real economy is always changing, someone needs to do something to “keep” the financial markets forecasting capital needs efficiently. It’s a weird theoretical place to end up.

But he’s right. Most market participants don’t think markets are so efficient that they can’t get some alpha out of it. So who does believe in market efficiency? Is there a group of people who believe it significantly more than Fama believes people that participate in markets believe it? Yes: Our regulators and our government.

You can see it in Judge Easterbrook’s statement on mutual fund fees, where since “It won’t do to reply that most investors are unsophisticated and don’t compare prices. The sophisticated investors who do shop create a competitive pressure that protects the rest” any observed difference between institutional and individual investor fees has to be the result of costs, as opposed to bargaining. It’s easy to read that differential the other way, that institutional investors have clout and individuals are getting squeezed, but since we take efficient markets to be true we start from the ideological other stance.

You also hear it in the background in other places. Let’s look at July 30, 1998 RR-2616, Treasury Deputy Secretary Lawrence Summers' testimony before a Senate Committee on the CFTC Concept Release. As a reminder, the CFTC, under Brooksley Born, wanted authority to regulate OTC derivatives. The Treasury (Rubin and Summers), SEC (Arthur Levitt) and The Federal Reserve (Alan Greenspan) wanted to stop this, and did. Born resigned and was replaced by one of Rubin’s assistants.

(By the way, there’s an excellent Frontline episode about this clusterfuck that is worth your time. My favorite is the gendered language here: “I didn’t know Brooksley Born,” says former SEC Chairman Arthur Levitt, a member of President Clinton’s powerful Working Group on Financial Markets. “I was told that she was irascible, difficult, stubborn, unreasonable.”

(I can only assume this is Ivy League-speak for “What? You believe a random firm could take on such a CDS position in the OTC market that their counterparty risk would destabilize the entire system? Why don’t you talk reasonably with us in a few days when you are off the rag.”)

Anyway, the testimony (my underline):

Summers: Mr Chairman, thank you for giving me the opportunity to discuss issues raised recently regarding the regulation of the OTC derivatives market — notably, the concept release issued last May by the Commodity Futures Trading Commission (“CFTC”)…

Once again, it is legitimate and valuable for Congress to consider whether it is necessary to make changes to the regulation of the entire OTC derivatives market. But I would note that it is not immediately obvious how either of these rationales applies in the case of the vast majority of OTC derivatives:

* first, the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws;

Ah, the late 1990s. “Yes there are some noise traders sloshing around out there but the idea that the financial sector wouldn’t get counterparty solvency risk perfect is outside the terms of reasonable debate.” There’s a lot of stuff going on there, hubris, subsequent cushy jobs at hedge funds and large banks, not rocking the boat, etc. But underlining this, for regulators, members of Congress, officials more generally, is the idea that markets will simply get this correct. And they did not.

Justice Holmes once famously dissented that it’s a form of judicial activism to base our courts on “an economic theory which a large part of the country does not entertain.” It seems like the same should be said for our government and our regulatory bodies, especially as they try and figure out how to fix the mess that is the financial markets. And it’s worth noting that the founder of this economic theory, The Efficient Markets Hypothesis, doesn’t even believe that people actually in the financial markets entertain it.

Comments

[Denis Gould:]

There are certain obvious fallacies which nevertheless persist. A belief that investment professionals can add value despite trading costs and management fees is one of them. The evidence is absolutely clear - active managers do not add value. And yet a huge hedge fund industry has grown up (charging massive fees) based on this clearly discredited premis.

Three reasons spring to mind. The first is simple hope over experience; I know the average manager will underperform, but I am smart enough to pick the winners. There is no evidence that anyone, even full time manager selection consultants, can do this.

The second reason is more fundamental. It is that the whole market can't just index.

And the third reason adds a moral twist. It is only the active managers that reward better corporate performance and therefore create market efficiency. Indexers grab a free ride on the back of the active managers.

Nov 06 04:33 AM

[Steve in Gr...:]

Yes, I do believe in market efficiency, absent government interference. There was a bubble in equities and real estate which burst in 2007-2008. The bubble was created by the Greenspan Fed holding interest rates too low for too long. Money supply manipulation by the government creates market signals which confuse (and are intended to confuse) market participants. The blow-up in CDS is one of the many disastrous results caused by monetary inflation by the Greenspan Fed. And Bernanke is Greenspan only moreso.

Nov 06 07:33 AM

[john s. gordon:]

here we have the "lake wobegon hypothesis":
'80% of all active managers are above average'/
arbitrage to be successful depends on market inefficiency.
therefore he who controls information controls the world.
> jack

Nov 06 08:42 AM

[Kid Dynamite:]

i believe markets are efficient in the sense that YOU (with YOU being anyone who doesn't do an extreme amount of work) can't beat them. MOST active managers fall under the category of "YOU." there are SOME who go out in the field and do their own channel checks, instead of talking to the company or the sell side - and these managers may be able to beat the market.

Interestingly, I claim that the recent financial debacle proves that markets are MORE efficient, not less - in the sense that many many managers who appeared to be generating tremendous excess returns in the preceding decade were exposed - and brought right back to at or below market average returns when they blew up. Perhaps their excess returns were generated not by alpha, but by leverage.

Nov 06 08:44 AM

[greaterdepr...:]

A multi-century history of bubbles and crashes disproves EMH soundly.


On Nov 06 07:33 AM Steve in Greensboro wrote:

> Yes, I do believe in market efficiency, absent government interference.
> There was a bubble in equities and real estate which burst in 2007-2008.
> The bubble was created by the Greenspan Fed holding interest rates
> too low for too long. Money supply manipulation by the government
> creates market signals which confuse (and are intended to confuse)
> market participants. The blow-up in CDS is one of the many disastrous
> results caused by monetary inflation by the Greenspan Fed. And Bernanke
> is Greenspan only moreso.

Nov 06 09:31 AM

[greaterdepr...:]

If it takes a market 10 years to realize reality, THAT is not efficient.
Markets are not efficient because people are not rational.


On Nov 06 08:44 AM Kid Dynamite wrote:

> i believe markets are efficient in the sense that YOU (with YOU being
> anyone who doesn't do an extreme amount of work) can't beat them.
> MOST active managers fall under the category of "YOU." there are
> SOME who go out in the field and do their own channel checks, instead
> of talking to the company or the sell side - and these managers may
> be able to beat the market.
>
> Interestingly, I claim that the recent financial debacle proves that
> markets are MORE efficient, not less - in the sense that many many
> managers who appeared to be generating tremendous excess returns
> in the preceding decade were exposed - and brought right back to
> at or below market average returns when they blew up. Perhaps their
> excess returns were generated not by alpha, but by leverage.

Nov 06 09:34 AM

[Windsun33:]

Markets are efficient, but not in the short term. In the short term they are driven more by hype, hope, rumors, and personal sentiment.

For example the bubble in solar and renewable stocks which are now coming down to realistic levels took two to three years to become "efficient". (On the other hand, it took just a very few weeks for (AONE) to come crashing down).

Nov 06 09:42 AM

[morph366:]

The EMH may be true and markets may well be "correctly" valued at any instant in time - but people are a bit fickle and they can massively change their minds about valuation in the blink of an eye.

Nov 06 10:45 AM

[enigmaman:]

The market is very efficient in taking other peoples money and putting it in their own pockets, they are so adept at it that they can do it over and over again year after year and all they need to do is promise to do better next time. The inefficiency of the market comes from the gullibility of the retail investor because they have no other option then to do the same thing over again with the same companies and hope it will bring a better outcome next time, this chicanery is fully sanctioned by the Fed Government, it a way to keep order by keeping the masses hopeful and in line though they know such hope is futile yet very convenient

Nov 06 11:21 AM

[JeffDB:]

A great well written article. Thanks for posting it for us.

Nov 06 11:55 AM

[rdd:]

I think a lot of Wall Street people do truly believe in market efficiency which is why they rely on getting inside information before anybody else in order to get their edge. It appears that they don't believe that they can get an edge in the efficient markets otherwise.

On the other hand, the traditional Graham & Dodd value investing model believes that the market will underprice securities that have short-term problems but long-term good prospects. Value investing wouldn't exist in a truly efficient market, yet it seems to be able to pull off a long-term (multi-decade) additional 1% or so of annual returns with some bumps and bruises along the way.

So, all of these people currently getting indicted for insider trading are effectively announcing to the world that they do not have the brains or fortitude to uncover the hidden inefficiencies in the market while the Warren Buffets quietly go about their business making money in the inefficient markets.

Nov 06 12:43 PM

[Graham and ...:]

Thanks for the plug for Graham and Dodd investing. I believe in that methodology myself, which is why I wrote a book about it.


On Nov 06 12:43 PM rdd wrote:

> I think a lot of Wall Street people do truly believe in market efficiency
> which is why they rely on getting inside information before anybody
> else in order to get their edge. It appears that they don't believe
> that they can get an edge in the efficient markets otherwise.
>
> On the other hand, the traditional Graham & Dodd value investing
> model believes that the market will underprice securities that have
> short-term problems but long-term good prospects. Value investing
> wouldn't exist in a truly efficient market, yet it seems to be able
> to pull off a long-term (multi-decade) additional 1% or so of annual
> returns with some bumps and bruises along the way.
>
> So, all of these people currently getting indicted for insider trading
> are effectively announcing to the world that they do not have the
> brains or fortitude to uncover the hidden inefficiencies in the market
> while the Warren Buffets quietly go about their business making money
> in the inefficient markets.

Nov 06 12:59 PM

[TinyTim:]

"“I was told that she was irascible, difficult, stubborn, unreasonable.”"

Notice no consideration of performance qualities like smart, experienced, good judgment, etc.

I saw that Frontline and Levitt later came back and commented on just how capable she was.

Nov 06 01:02 PM

[JohnDough454:]

do you also believe in the tooth fairy?

You just watched some of the biggest, smartest financial companies in the world destroy themselves by not managing risk properly yet you believe in efficient markets?


On Nov 06 07:33 AM Steve in Greensboro wrote:

> Yes, I do believe in market efficiency, absent government interference.
> There was a bubble in equities and real estate which burst in 2007-2008.
> The bubble was created by the Greenspan Fed holding interest rates
> too low for too long. Money supply manipulation by the government
> creates market signals which confuse (and are intended to confuse)
> market participants. The blow-up in CDS is one of the many disastrous
> results caused by monetary inflation by the Greenspan Fed. And Bernanke
> is Greenspan only moreso.

Nov 06 03:29 PM

[JeffDB:]

On Nov 06 09:34 AM greaterdepression wrote:

> If it takes a market 10 years to realize reality, THAT is not efficient.
>
> Markets are not efficient because people are not rational.
-------
But it seems to me that some of the bubbles and other irrational behavior is attributable, at least in part, to irrational behavior on the part of the government. For instance, our monetary policy now is prone to create imbalances and misallocation of resources. If the government is monetizing a massive deficit, the money supply is growing above any increases in productivity and yet interest rates are at or near zero, people are going to be "pushed" into making other riskier investments. In a normal environment those investments would obviously be irrational but the government is itself creating an irrational environment, and the irrationality of the investments aren't as readily apparent until the bubble pops.

Similarly, it can be difficult to predict what the proverbial elephant in the room may decide to do at any given moment. One's investments may look quite rational in a given scenario, but any particular strategy can get hammered if underlying assumptions change suddenly. A sudden about face on interest rate policies, or a government suddenly unloading tons of gold or intervention in the markets in various ways can change things on a dime. Elections, regime changes elsewhere, war, hurricanes etc. can change things pretty quickly.

I'm a little torn by the debate. I've seen the studies showing professional money managers as a whole have done poorly against vanilla index funds, and that a monkey throwing darts at a board outperformed the majority of pros in at least one other study, and yet I like to think I still have a shot. Ben Graham, Graham & Dodd, Warren Buffett & others have shown that it is possible, and it seems to make sense that it should be.

Even I was very skeptical of the dot.com bubble & the various investment vehicles funding the housing bubble, and I'm just a layman. But I also realize there are a lot of powerful forces and variables in play that could easily overwhelm whatever calculations & strategies I might come up with or subscribe to at a moment's notice.

The little guys are also at a decided disadvantage to the insiders, the well connected and perhaps those with technological advantages but it seems that there might still be enough inefficiency to make it worthwhile to play anyway. But like someone in a small boat at sea, there are risks involved and sometimes it's best to play it safe and get out of the water. ;)

Nov 06 03:41 PM

[Windsun33:]

The MARKET may have some efficiency, that does not mean that individual companies do. The market eventually said that those companies suck, and if not for all the government bailouts, they would have gone extinct.


On Nov 06 03:29 PM JohnDough454 wrote:

> do you also believe in the tooth fairy?
>
> You just watched some of the biggest, smartest financial companies
> in the world destroy themselves by not managing risk properly yet
> you believe in efficient markets?

Nov 08 11:33 AM