I Really Want To Crush The Efficient Market Hypothesis...

by: Cullen Roche

This is my OCD speaking again and I'm not gonna beat around the bush here. I have a big problem that I need to solve in the coming decade. You see, Eugene Fama has sparked a bit of an investing revolution by convincing the world that the Efficient Market Hypothesis and "passive investing" are sound approaches to the world. As a macro monetary theorist who rejects most things out of the Chicago School of Economics due to its highly politicized views, I have a big problem with these ideas because I think that the same sort of politicization in the macro econ work has filtered over into the finance work. It's very cleverly marketed, but largely based on the same erroneous underlying positions like "rational expectations" and whatnot. Anyhow….

Barry Ritholtz posted a link to a video called "Winning the Loser's Game" on Twitter (you can watch part 1 here and part 2 here). The conclusion is something that's becoming very popular these days - the idea that, in investing, you can't go wrong with a low cost passive indexing approach. It's true to some degree. The less active you are the more you'll reduce frictions like tax inefficiencies and costs. But the very foundation of the idea of "passive indexing" is based on a misunderstanding of the way markets function at their macro level. In fact, passive indexing is, by definition, portfolio construction resulting not only in active asset picking, but active asset chasing. Let me explain.

As I've explained previously, there is no such thing as a truly passive portfolio. That is, the only "passive" approach would be buying all of the world's financial assets and simply taking the market return it generates every year. Of course, you can't do this because no such product allows you to do this. So you must, by definition, actively choose to allocate your assets in some manner.

What's interesting about the Global Financial Asset Portfolio (GFAP) is that it's basically a 55% bonds and 45% stock portfolio at present - an allocation that runs counterintuitive to the way most of us are taught to allocate assets with a stock heavy "buy and hold" methodology. Most of us actively choose to reallocate the GFAP into something else which, as Cliff Asness has clearly stated, is nothing more than an active management decision often cloaked by another "passive" name:

You can believe your strategy works because you're taking extra risk or because others make mistakes, but if it deviates from cap weighting, you don't get to call it "passive" and, in turn, disparage "active" investing. This peeve may be about form over substance-marketing versus reality-but these things count. - "My Top 10 Peeves" by Clifford S. Asness

What's most interesting about these videos and the "passive investing" approach is that its grounded in the idea of Eugene Fama's Efficient Market Hypothesis, a theory with faulty underlying foundations and several internal inconsistencies. The most glaring internal inconsistency is the very terminology itself and its advocacy to "passive" investing based on the idea that the markets are smarter than the rest of us. Eugene Fama, who popularized the EMH, did not seem to understand that, at the macro level, the current snapshot of global financial assets is an ex-post view of how inefficient markets are currently allocated. That is, it is a largely reactive allocation to macro trends. More importantly, the GFAP is a dynamic portfolio that changes over the course of its lifetime to account for changes in macro trends.

For instance, in the 70s & 80s the GFAP was equity market heavy while the current GFAP is bond heavy. When one accounts for the risk adjusted returns this portfolio has proven to be positioned entirely incorrectly for decades at a time as it adjusts to changing macro trends. The investor who was bond heavy in the 1980s substantially outperformed the equity heavy portfolio on a risk adjusted basis while only slightly underperforming on a nominal basis. In other words, the markets and the GFAP did not produce the most optimal outcome for investors.

This is why investors who were bond heavy like Cliff Asness, Ray Dalio, Bill Gross are held on such high pedestals - they took a proactive view of the environment by accounting for the reality that bonds were undervalued relative to stocks. Today, we're at the nearly exact opposite environment yet the GFAP would tell you to be bond heavy 30 years after the optimal time to do so. In other words, an indexing purist is chasing a trend at its worst possible time. Therefore, the truly passive investor is simply chasing performance and very likely to generate sub-par returns in the coming decades.

What's so fascinating about this view of the markets is that it's been used to demonize any form of "active" investing without realizing that we are all making active decisions by deviating from the GFAP. Worse, anyone who blindly follows the GFAP (as an indexing purist would) is simply relying on the ex-post snapshot of the markets without realizing that their returns rely largely on chasing macro trends that have already played out.

When someone tells you to invest "passively" in index funds they likely don't understand three important facts:

  1. There is no such thing as "passive investing". Therefore, by definition, indexers are always advocating some form of active "asset picking", but rationalizing this based on some other theoretical underpinning such as "factor tilts" or "risk tolerance" which are also known as excuses for active asset picking.
  2. They are engaging in a forecast of some type even though they often market themselves as "forecast free" investors. This is due to the fact that any portfolio with a directional bias has an underlying dependence on the performance of the underlying macro economy to some degree. An equity heavy portfolio relies on economic expansion whether you call that a "forecast" or not.
  3. A passive indexing purist is, by definition, a performance chaser since the GFAP allocation is nothing more than an ex-post snapshot of macro trends. This portfolio, with certainty, will position you poorly at times during economic cycles and therefore requires an element of active reallocation. Smart investors who reject nonsense like "rational expectations" will identity these periods and turn against the "wisdom of the crowd".

Ironically, "passive" investors often demonize "active" management of any type without understanding that they themselves are almost always active. Worse, a truly "passive" portfolio is nothing more than an ex-post snapshot of the way markets have responded to macro trends. Therefore, these portfolios often result in the same type of portfolio chasing that "passive" indexers demonize investors for. What in the world is rational about being overweight bonds AFTER the greatest bond bull market in history? But that's exactly what an indexing purist would advocate today unless they applied Fama's "factor tilts" or other theoretical excuses for active asset picking.

We have to be careful with this "passive" investing ideology. Yes, you should be concerned about fees and frictions. If you pay someone 1% a year for portfolio management then you're likely overpaying for their services. But at the end of the day indexers should know that asset allocation decisions are the primary driving factor in returns and almost all indexers are involved in a form of active "asset picking" that will drive their results. And whether that asset picking is based on any underlying rational premise is highly debatable. One thing I can assure you is that if it's based on a rationale similar to the EMH then it's probably got some glaring holes in it.