On a roll?

The efficient market hypothesis hinges on the notion that financial asset prices adjust so quickly to new information that no excess returns can be earned. So is it just luck that allows investors to beat “efficient markets”? Vanessa Drucker, Fund Strategy’s American
editor, reports.

Imagine you are driving Iaround a crowded city, looking for a parking spot. You know there are a few empty spaces left, and some lucky souls will find them. You also know it is unlikely to be you. However, if you are observant and experienced, you may be aware that in some parts of town you are more likely to find that rare spot, although not always, of course. But you will enjoy better odds for a while. Soon word will get around, and there will be no more spaces left there either.

Efficient market hypothesis (EMH) theories do not recognise such exploitable opportunities. According to proponents, financial asset prices adjust to new information so quickly that no excess returns can be earned before arbitrageurs pile in to buy any mispriced securities. “You might be lucky over a short interval, but overall markets impound new information so fast that unless you are Johnny-on-the-spot, you have no hope,” says Hersh Shefrin, a professor of finance at Santa Clara University.

Some academics and practitioners still adhere to an efficient view. Others, such as behaviouralists, maintain that markets are efficient some but not all the time. Michael Edesess, partner and chief investment officer at Fair Advisors, in Denver, Colorado, points out that, “nobody ever believed EMH was 100% true. It’s not like a physical law. Its developers made the mistake of using the formulation that market participants are ‘rational’, a poor choice of adjective. Of course no one is completely rational, but I don’t think this necessarily discredits EMH.”

Paul Samuelson, a Nobel laureate economist, first put forward the concept in the early 1960s. He circulated the obscure work of Louis Bachelier, who had written in 1900 that, “the mathematical expectation of the speculator is zero”. Eugene Fama picked up the banner, with a dissertation in 1965, and codified three subconcepts, under the rubric EMH. He argued that efficiency could exist in weak, semi-strong and strong forms. The weak state allows for some fundamental analysis to produce excess returns, but the market still follows a random walk, whereby past price patterns never predict future movements. The semi-strong form requires nearly instantaneous price adjustment to information, and rules out any advantage from technical or fundamental research. The strong form leaves no room for excess profits derived from public information.

Fama said the markets produce the best estimate of true intrinsic value, a nuance often overlooked. His focus was squarely fixed on earning returns, and not on whether prices and fundamental values coincide, or if prices correctly impound information. That is important, because if many investors are subject to behavioural biases, then even if they could theoretically reap abnormal returns, most will not have the brains or fortitude to do so. Shefrin summarises, “Seeing whether people are making abnormal returns doesn’t test efficiency, but only whether they are successful.”

These theories were a source of great tension for the practicing community. “The notion that stock prices moved according to a random walk implied that most of the investment world was wasting its time,” Shefrin says. He adds, “by the end of the 1970s, the academic community largely believed that two principles – EMH and the capital asset pricing model [CAPM] – would explain financial markets and everything else for the rest of eternity.” CAPM, which runs in tandem with EMH, states that if you want to earn higher returns, on average, you must accept more risk in your portfolio.

Edesess, meanwhile was working at a pension fund on Wall Street from 1971 to 1975. Employed at AG Becker, his goal was to beat the Standard & Poor’s index, and he was reading the academic studies. Soon he performed his own studies on his gigantic database. “Mine was probably better that that of the academic researchers. They were using public mutual fund data, while I had access to my pension fund clients’ data,” Edesess recalls. He ran autocorrelation series’, taking each quarter’s performance numbers, moving them forward, and correlating the two series’. “It soon became clear that it made no sense to try to beat the index by anything. Moreover, paying managers more showed no correlation with performance. You couldn’t do it by hiring the most expensive manger with the best record.”

Next, in the 1980s, several empirical pieces created a stir, by suggesting that CAPM and EMH might be subject to anomalies. Rolf Banz published a paper showing that small cap stocks earn more abnormal returns than their betas would indicate. Others questioned outperformance from low price-to-book names, while David Dreman studied low price-to-earnings results. “The EMH guys hated us a long time,” Dreman told me in a 2007 interview. “One problem was that before 1980, their databases were not that good.”

In 1984, Richard Thaler and Werner De Bondt began to argue that people overreact to both good news and bad. Investors place too much reliance on past performance, and expect trends to continue. Yet they should expect losing stocks to outperform winners. Investors are ignoring regression to the mean, which is the missing link. The quest for anomalies went on intothe following decade. In 1995, David Ikenberry, Josef Lakonishok and Theo Vermaelen published a study that considered the impact of management’s insider judgment. It appeared that, from within a company, managers were best equipped to assess the intrinsic value of their shares. When redemptions were high, or share issuance low, those securities tended to prosper. Then, in 1997, Mark Carhart added momentum to the list of exceptions.

More recently, the arguments have shifted in the face of humungous, irrefutable bubbles. Both the Nasdaq tech bubble and the subsequent real estate explosion have been something of an embarrassment for the EMH school to explain. “Bubbles tell us that prices and fundamental values surely do part company for periods of time. If your notion is based on whether prices and values coincide, the answer is that they don’t,” says Shefrin. Bubble phenomena arise from herding behaviour, and from how investors act in aggregate, distorting entire asset classes.

Market crashes and panics pose a related problem for EMH. “EMH relies on arbitrageurs to flex their collective muscle,” says Randy Kurtz, at RK Investment Advisors in New York City. He says, “during normal periods, when EMH rules the day, there are plenty of people playing the role of arbitrageurs, purchasing underpriced and selling overpriced assets. In economic panics, the arbitrageurs themselves may be capital constrained.”

The debate still rages, with direct consequences for investors. Scott Mosley, who runs an independent investment firm in Madison, Wisconsin, must constantly address his clients’ questions as to whether they should be using ETFs or passive strategies. In an effort to identify the optimal course for them, he has personally examined Morningstar data for 4,295 American-based equity mutual funds, using a three-year aggregate. After all, it is generally agreed that large, liquid, developed equity markets are the most efficient, and least likely candidates for creating alpha. Within his sample, he discovered that 1,262 of the funds exhibited positive alpha. He then whittled that down to those that display more than 1% in excess returns, arriving at 826 funds. The quoted returns do not include sales charges, so “if you are paying 5% in charges, you are in the hole,” Mosley reports. He asks, “Can you get your hands on those funds? Are they open or closed? That limits the field even more.”

Tom Wilson, a financial adviser and managing director at Brinker Capital, in Berwyn, Pennsylvania, also discusses the pros and cons of active and passive strategies with his clients. He concludes that in bull markets, which are producing above-historically normal returns, a passive approach works better, and vice versa. Wilson points to a study generated by Lipper: in 2005, when the S&P average returned only 4.93%, 61% of active managers succeeded in beating the benchmark. The following year, in 2006, the S&P produced a more impressive 11.8%, but only 19% of the managers were able to trounce it. “It’s not as if all those managers forgot how to manage money,” Wilson comments.

Index funds and passive investors are in theory obliged to remain invested at all times, instead of preserving a cash component. “Everyone thinks indexing will do as badly as the bear market itself,” says Christine Franquin, who works from Brussels as head of Index Portfolio Management For Vanguard. “As the market sinks, that seems inevitable without cash.”

Perhaps the “myth” of bear market underperformance is not so clear cut after all, Franquin urges. The main advantage of indexing in bear climates is the requirement of staying fully invested in all styles. Thus, diversification is preserved. In uncertain times, it is difficult to shift direction in a portfolio, to reflect a changing trend.

During the 2002 bear market, many investors remained overweight in technology and growth, clinging to the hope that the new paradigm would revive. Index funds, on the other hand, had remained invested in both the old and new economy, through thick and thin. During the ugly years from 2000 to 2003, active managers in Europe significantly trailed the MSCI benchmark. From a sample of 796, 77% of active managers fared worse than the index, with only 23% beating it, per Vanguard.

But the most critical element is that, as the bear retreats, markets tend to pick up suddenly and rapidly. “That’s when we see most of the outperformance,” according to Franquin. While active managers need to put money back to work, it almost always takes a while before they are confident the bear is gone for good. As a result, they lose the profitable part of the run associated with the turnaround into bull territory.

With both EMH and active camps lined up at either end of the arena, there is still a powerful case for the middle ground. In deep liquid markets, informational advantages rarely work, leaving few opportunities for easy gains. Think of it as a continuum.

America. Treasuries, which trade in liquid markets dominated by institutions, represent one extreme of the span. Next, large capitalisation equities, whose pricing involves discounting uncertain cash flows, are also usually efficient.

It is hard to achieve anything exceptional in that class, without either luck or non-public insider information. Considering that about 15 American analysts cover a stock like General Electric, it would be difficult to unearth overlooked information.

A notable divide follows, as the spectrum shifts toward smaller caps, corporate and municipal bonds, and international and emerging market equities, which are less closely researched and scrutinised. Fixed income classes do not lend themselves well to indexing. Most fixedincome indexes, which have many securities, cannot easily be replicated. At the far end, illiquid opportunities, such as real estate or private equity, may rely on non-public information.

Out on the wide middle ground, some managers find room to combine an active and passive/efficient philosophy. Larry Luxenberg, who runs Lexington Avenue Capital Management from Rockland County, New York is a card-carrying advocate for passive strategies, at least over substantial time-scales. However, he prefers to use Dimensional Fund Advisors’ funds for carving up whole style sections of the market, like large/small cap, growth or value. “It’s 99% mechanical, but that little bit of flexibility makes a big difference in returns. Someone who tries to match the S&P exactly must buy at an exact point in time, but I can buy or sell between spreads over several weeks.” He is also replicating a wider exposure, of 2,000 to 3,000 stocks. As those 1980s studies demonstrated, small cap and value stocks do appear to enjoy a tailwind. The DFA funds can capture that, by holding a larger component of smaller companies. For most mutual funds, small caps are prohibitively expensive to trade.

Asset class rotation is another fruitful area for making active bets in market direction. Beebower Hood and Brinson’s famous study from 1986 discussed how 93.6% of their sample pension funds’ returns could be attributed to successful asset class allocation. Certain managers engage in tactical asset allocation. “We rotate as we see opportunities,” explains Michael Kitces, director of Financial Planning at Pinnacle Advisory Group in Columbia, Maryland. Economies go through cycles, while some sectors do better, causing markets in aggregate to overshoot in those areas. Kitces therefore invests cautiously, to avoid high risk sectors that may be overheating. He says, “You can make a killing by owning the cheapest stock, but equally by not owning what is risky.” A simple method is to buy an index, and chop out the least attractive segments.

Yet few American funds practice sector or asset class rotation. Why not? For one reason, the industry has evolved down a path of picking asset classes first, and managers afterwards. As Kitces recounts, most conversations with his clients typically might proceed thus: I need exposure in, say, large caps. Should I buy an index, or find a large cap stock manager? As a second deterrent to rotation strategies, it is extremely difficult to benchmark whether someone is doing well. If, for instance, one were to pick subpar performing managers in every top performing class, returns would still be abysmal.

Some gains may be available from tailoring an EMH route, nipping and tucking to protect against pitfalls or seize glaring opportunities. Nonetheless, for most investors, a passive strategy is still sound. “Your biases will be larger than the anomalies. So invest as if Fama is right, even if he turns out to be wrong,” Shefrin suggests. “Generally we believe that the US equity markets and fixed income markets are fairly efficient, but that behavioural tendencies can have a significant impact on market movements,” adds Bruce Bond, president of Powershares, an ETF fund family.

As a practical discipline for overcoming natural biases, EMH joins forces with behavioural finance. Behavioural finance, and its sister, behavioural economics, provide topical fuel for financial authors and journalists, since “you have to keep coming up with something new!” Edesess says. While it may be a little faddish to hype behaviouralism, academics have motives to keep the pressure up against EMH. “They can make more splash and pizzazz when they come out with a paper that claims to have found a kink in the armour,” says Paul Brakke, head of Global Structured Products Group at State Street Global Advisors.

Outside the ivory tower, there are even fewer inducements to encourage clients to forego active analysis and bets. In furthering their own business, most investment professionals have little incentive to promote the passive avenue. It is in their interests to keep returns noisy and information confusing.

Randy Kurtz describes his previous role, a few years ago, working at the Large Cap Value fund at Bear Stearns Asset Management, where he dealt with a universe of 50 stocks. “Most of the prices seemed about right,” he says. “I would only find a screaming buy a few times a year.” At Bear, he would participate in a weekly meeting, where investments were sorted by their projected upsides. Kurtz noticed that most of those upsides constituted about 10%, only slightly above an overall market bet. “Yet here we were, charging clients on the 80% or so of a portfolio we believed to be fairly priced.”

One need not be a financial expert to grasp the basic premise. Most people are sceptical when their neighbour comes to them with a get-rich-quick scheme, which is the common version of earning abnormal returns on their savings. “In the 1400s, people tried to raise money for an invention for spinning wheat into gold,” says Brakke. Of course, some managers do succeed in earning abnormal return – for a time, anyhow. We see it over and over. But the questions are, can you pick those stars out? And how long will their achievement persist?

Why should investors eschew the more straightforward route to earning their fair share of the market return, in favour of long-odds, active bets? A good metaphor comes from the multibillion dollar diet industry. Most of us accept that if you consume less or expend more calories than you take in, you will lose weight. That is free advice. Yet every new diet, from low carbohydrates to Eskimo regimes to caveman fare, lures hopeful consumers. Investors take note of similar advice: keep costs low, and resist the urge to gamble unless you are positive you command an informational edge.

A bet against making bets
Randy Kurtz, of RK Investment Advisors in New York, had a moment of revelation when he was a graduate student at Columbia University. Warren Buffett, who was lecturing, told the assembled students that, looking back, he himself only gets about one good idea a year. “And that was coming from the most famous money manager of all time!” Kurtz says.

Buffett is often upheld as an exception to the argument that it is well nigh impossible to beat the market in the long term. Even the Sage of Omaha could not resist a flutter. Buffett has long maintained that hedge fund fees are too expensive. Early this year, he placed a wager with Protégé Partners, a New York City money management firm that took some highly successful positions in 2006 against subprime mortgage securities. The terms of the bet are that over the next 10 years, the S&P will return more than Protégé’s selection of five funds of funds, the identities of which will be secret. Each side has put up about $320,000 (£182,000), which was used to buy a zero-coupon treasury bond. When the bond matures, 10 years down the road, it will be worth about $1m. Each of the protagonists has agreed to donate the winnings to charity.

Is Buffett really putting his chips on a passive versus active strategy? Not exactly. By choosing the S&P 500, rather than the Wilshire 5000, or even a more global benchmark, he is rooting for large cap American stocks. Every May, at the annual Berkshire Hathaway shareholders’ meeting, the score of the horserace will be reported.