With the potential for profits so large, it should not be surprising that huge amounts of resources are thrown at the problem of finding and exploiting anomalies in prices. We might define an anomaly as profits from strategies that are not explained by incremental risk taking. And with the combination of intellectual talent and the power of today’s computers, we should not be surprised when, occasionally, the search for an anomaly (increased returns without taking increased risks) proves fruitful. Markets are not perfectly efficient. However, they tend to be incredibly efficient at eliminating anomalies once they are discovered. The explanation for this phenomenon is what might be called the “tyranny of the efficient markets.”
The Efficient Market Hypothesis [EMH]
There are actually three forms of the EMH. The first is what is called weak-form efficiency. The implication of weak-form efficiency is that it is impossible to forecast future price changes using past price changes—technical analysis cannot produce excess profits. For many years, however, the major spot currency exchange rates and their associated futures prices were anomalies that produced profits when trend following rules were applied to them. This led to the widespread use of technical models by traders and investors. The question is: Should we expect this anomaly to persist? The answer is a clear no. The reason is that profits on overused strategies disappear. Economics professors Lee and Verbrugge explain:
The efficient markets theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns. (Endnote 1)
The study, “Do Foreign Exchange Markets Still Trend?” examined the major currency futures contracts, which have been trading since the 1970s, and more recent contracts on some of the more exotic currencies that began trading only a few years ago. The main conclusion of the study was that “the era of easy profits from simple trend- following strategies in major foreign currencies is over. The markets have adapted to the extent that profits from these simple trading strategies have vanished.” The authors found that while “trend-following models performed very well until 1995, since then profits for all currencies have declined and more than half have been negative—results that are even worse than could be expected from chance alone. The only currency with substantial profits following 1995 is the Japanese yen, and the yen’s profit vanished after 2000.”(2)
Markets Adapt Rapidly
As we should expect, traders adjust their strategies to reflect the popularity of trend following. Lee and Verbrugge offered the following as one possible explanation for why profits vanished: “traders, anticipating a trend, all try to initiate their positions simultaneously, resulting in a step function response in the currency to news rather than a smooth, trending response. In such a scenario, only the first and quickest traders would make money. Another explanation could be that the ‘dumb money,’ which had never previously recognized exchange rate trends and had systematically lost money in these markets, finally got smart, too. At any rate, in 1995–1999 and certainly by the post–2000 period, it was no longer possible to earn profits using moving average trend following trading rules in the major dollar currencies.”(3) This is a perfect example of the “tyranny of efficient markets.”
While markets may not be perfectly efficient, the most prudent approach for investors is to act as if they were. With the amount of capital available to hedge funds and investment banks, and the talent being dedicated to finding and exploiting anomalies, it does not seem likely that one can persistently exploit any such anomaly for very long. The market is just too efficient at eliminating “excess profits.”
Thus, the next time you hear about a strategy that is designed to exploit an apparent anomaly be wary of the “sharks” that are asking you to jump into the pool with them. It is highly likely that the anomaly is already well known and, thus, likely gone. And ask yourself these questions: Do they really need my capital to exploit the anomaly? Why are you entitled to the excess profits? If it really is an anomaly, why are they willing to share the easy money with me? The answers should be obvious. Even if the anomaly has not been yet fully exploited, it is likely that while the gross returns from the strategy might generate abnormal profits, it is not likely that the net returns will. In other words, the abnormal profits will go to the scarce resource, the intellectual capital, and not your capital. The marketing of such strategies is a well-known way to transfer assets from investors to investment bankers.
1. Dwight Lee and James Verbrugge, “The Efficient Market Theory Thrives on Criticism,” Journal of Applied Corporate Finance (Spring 1996).
2. Kuntara Pukthuanthong-Le, Richard M. Levich and Lee R. Thomas III, “Do Foreign Exchange Markets Still Trend?” November 13, 2006.
Disclaimer: Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn’t Want You to Know (2000), Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today (2002), and The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003), and co-author of The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006). He is also a Principal and Director of both Research of Buckingham Asset Management and BAM Advisor Services — a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices — in Clayton, Missouri (www.bamservices.com).
His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.