There Are Conceptual Limits to Efficient Markets

by: David Merkel, CFA

I do and don’t believe in the efficient markets hypothesis [EMH]. I do believe in the adaptive markets hypothesis [AMH]. The efficient markets hypothesis posits that:

  • Past public information can’t be used to obtain better-than-average returns. (weak form of the EMH — cuts against technicians)
  • Past and present public information can’t be used to obtain better-than-average returns. (semi-strong form of the EMH — cuts against fundamental analysis)
  • Public and private information can’t be used to obtain better-than-average returns. (strong form of the EMH — believed by few)

In practice, the academic community holds to the semi-strong form, while the investment community holds to the weak form. One thing is certain: the market is dominated by large institutions, and the market on the whole, less fees, cannot beat the returns of the market on the whole.

Part of the problem with the EMH is that with respect to the market as a whole, of course it is true. The real question is whether any particular strategy covering a small portion of the assets of the market can consistently beat the returns of the market on the whole. I believe the answer to that question is yes.

An implicit assumption of the EMH is that research costs are free. They are not free. Also, it implicitly assumes that a dominant number of investors understand what information drives the markets. Both assumptions are not true — even in the most clever firms, there is information that is missed, and research costs are expensive, and not always rewarded.

But the effort to earn above-average returns forces the market closer to the EMH. When the competition is tough, finding excess returns is hard. This makes it a limiting concept. We never get there, but effort to find above-average returns gets us closer to that ideal. Conversely, when many decide to index, those who do not index have a better chance at earning above normal returns, because there is a large chunk of naive capital in the market seeking average returns with certainty.

I want average people to use index funds for many reasons:

  • It lowers their costs.
  • It is tax-efficient.
  • Most people aren’t very good at picking equity managers. They go for the manager who is hot, in the style that is hot, rather than one that did better in the past, and is in a cold spell now. They go for large fund groups that spread their research over large asset bases, diluting whatever skill they might have. The best managers are the smaller specialists running their own funds, and who eat their own cooking. They are also inconvenient to use.
  • It improves conditions for the remaining active managers.

I also want them to buy-and-hold (dirty words) because they aren’t very good at market timing, and also have enough in safe assets to lower the downside of returns to a level that does not panic them. Most people are bad at most investment decision-making. Better to hand it off to those who don’t panic or get greedy, than to be a part of those who buy into tops or sell into bottoms.

On the AMH, quoting from another piece of mine of the topic:

The adaptive markets hypothesis says that all of the market inefficiencies exist in a tension with the efficient markets, and that market players make the market more efficient by looking for the inefficiencies, and profiting from them until they disappear, or atleast, until they get so small that it’s not worth the search costs any more.

And so it is for those of us who are active managers. We have a twofold task:

  • Base our strategies in areas that are unlikely to be overfished for long — e.g., low valuation, positive momentum, and earnings quality.
  • Dip into areas that are temporarily out of favor, whether those are industries, countries, or odd risk factors. (Odd risk factors: occasionally certain factors in the markets are poison, and even the slightest taint marks a security off-limits, even though those that are barely affected are fine. My example would be Enron-like structures 2001-2002. Few would buy the stocks or bonds of companies that had them, even though those structures were not large enough to impair the company, as they did with Enron. We bought the bonds of a Dominion subsidiary with abandon, because we knew the covenants the bonds had would not kill Dominion, and we had extra value as a result. What killed Enron benefited us, indirectly.)

To active managers then, I warn: watch how your main strategy goes in and out of favor. It happens to all of us. Add to your main strategy most when it is out of favor, and add to whatever alternative you have when your main strategy is running hot.

To average investors, then, I advise: if you adjust frequently, add to your winners and prune your losers. If you adjust infrequently (once a year or less), prune your winners and add to your losers. In the short run, momentum persists, in the longer-term, it mean reverts.

Know yourself. If you are prone to panic and fear with investments, better to hand the job off to someone competent who will be dispassionate. If you have conquered those emotions, you can potentially do better yourself in investing. But ask yourself what your sustainable competitive advantage is in investing. If you don’t have one, better to index.