Efficient Markets

The efficient market hypothesis (EMH) can be summed up with the following statement:

An efficient capital market is one in which security prices fully reflect all available information.¹

What does this statement mean? It implies that all information that is commonly used to make investment and trading decisions is already accounted for, without bias, in current prices. It implies that technical and fundamental analysis have no value in beating the market. It implies that luck is the primary factor in determining investment manager winners and losers. It implies that buying and holding the market over the long term is the most logical approach to participating in the markets.

The EMH can never be proven either empirically or mathematically. However, this is one economic idealization that is actually pretty useful in practice. There is an enormous amount of academic evidence that is consistent with the EMH. The efficient markets logic is also very compelling. As a trader, we need to acknowledge that dealing with the mechanisms that make markets efficient is part of the game.

Trading books never talk about efficient markets or its implications. If they do, it’s done quickly and disparagingly. Why is that?

One reason is human nature and hubris. Hardworking people who’ve enjoyed success throughout their lives tend to feel they are above average in this game also. This is especially true among the Type A personalities who tend to work on Wall Street and become hedge fund managers and traders.

Another is reason is naiveté – smart people entering the game from other fields (engineering and physics, for example) don’t understand how adaptive competition makes this field different than solving engineering and scientific problems.

Many participants just don’t fundamentally believe that markets are efficient, no matter what the evidence to the contrary.

These are all interesting reasons, but before getting to the major driving reason why most investment professionals don’t believe in market efficiency, let me tell you where I stand. I believe markets are efficient the great majority of the time, that beating the market over the long term is extremely difficult (but doable), and maintaining a highly respectful view of market efficiency is a very good place to start in searching for trading edges.

By far, the most dominant reason trading book writers, trading system sellers, newsletter writers, mutual fund managers, hedge fund managers and commodity trading advisors do not believe in efficient markets is because it’s bad for business. “Beating the market” is the business for most investment professionals. They can’t show weakness with respect to this question because customers get a bit nervous when their service provider appears uncertain about the value to be provided.

The financial rewards for managing other people’s money are just too great. Smart and talented individuals can become immensely rich, famous and powerful managing other people’s money. The vast majority of folks in the financial services industry are good people with good intentions. But, they have families to support, so any threat to their livelihood will be vigorously combated.

Ask financial professionals if markets are competitive, and the answer will definitely be yes. Ask these people if the market is efficient, then it’ll definitely be no. Ask them if they’d build a lemonade stand on a street with three other lemonade stands – obviously the answer is no, because there’s already too much competition. Ask them about the thousands of competitors in the investment management arena and you will get a variety of answers about why they can still beat the market due to their process, experience and skills.

The fundamental basis for efficient markets is not some academic mathematical model with lots of unrealistic assumptions. Efficient markets is essentially based on competition. It’s about traders and portfolio managers searching and exploiting edges until the alpha goes away. It’s about a “wisdom of crowds”² effect as self-interested participants search for mispriced securities, and initiating trades that help pushes prices back to an appropriate unbiased equilibrium price.

I’m highly respectful of the efficient markets view. To be a successful trader, you need a certain amount of humbleness and an understanding of the game. You can’t expect to find enduring trading edges if you’re oblivious to the EMH logic. You’ll fall for many sales pitches and succumb to many back-tested studies.

In other words, you need to be extremely wary of the possibility that hundreds of your competitors (who are probably smarter and more experienced than you) have already investigated the approach, and if there are profits to be made, they are already exploiting the opportunity, sucking out what little alpha is still there. Even worse, you’re probably too late to the party, with the trading edge already too crowded to deliver future alpha.

I recommend that any new trader read about the EMH, kind of like studying the enemy. From a scientific point of view, it’s very powerful stuff. There are thousands of academic papers on the subject, so I wouldn’t go there; although an occasional survey article can be interesting.

Here is a recommended reading list of books that touch on the subject:

• Common Sense on Mutual Funds by John C. Bogle, 2009, especially the section on indexing. See also previous editions, such as the first in the series, Bogle on Mutual Funds, 1994. This book was very influential for me when I first started trading and investing.
• Evidence-Based Technical Analysis by David Aronson, 2007. Chapter 7. This book does an good job describing the EMH and its consequences for technical analysis approaches.
• Inefficient Markets by Andrei Shleifer, 2000. It’s very technical, but the first couple chapters provide a good discussion of the assumptions behind the EMH.
• Modern Portfolio Theory and Investment Analysis by E.J. Elton and M.J. Gruber, various editions. Mine is the 5th edition, published in 1995. Read the chapter on Efficient Markets to understand the various tests and evidence supporting the hypothesis. See also the Efficient Capital Markets chapter in Investment Analysis and Portfolio Management by F.K. Reilly and K.C. Brown, 6th edition, 2000.
• The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox, 2009. This is an excellent and entertaining book on the evolution of the efficient markets view throughout modern history.
• The Quest for Alpha by Larry E. Swedroe, 2011. This is a very readable discussion regarding the practical implications of an efficient markets view.

The EMH Logic

The arguments in favor of the EMH are based on logic and common sense. With respect to competition, there are tens of thousands of mutual funds and hedge funds in the world competing with each other to add alpha. Every year, many hundreds of funds are opened and shuttered. Success of one manager will attract immense competition from others, which will act to diminish the alpha source used to produce past superior returns. Common sense suggests that with a reasonably level playing field, with few barriers to entry, future winners will be very difficult to detect within a noisy performance environment. Distinguishing between luck and skill will be onerous. If skill was involved, there is still much uncertainty regarding the trading edge in the future – will it be competed away or diluted by a much larger asset base, among other worries.

Then there’s the logic associated with aggregate investor performance, nicely argued by Bogle in his book Common Sense on Mutual Funds. Let’s start with the stock market. Since all investors collectively own the stock market, the aggregate investment return for all investors is equal to the stock market return. Among professional investors, who dominate stock market trading, each year there are winners and losers with respect to delivering risk-adjusted performance, but in aggregate their gross return will be that of the stock market.

Perhaps the professionals have another group of investors to exploit in aggregate, such as foreign investors, retail investors, pension funds, and governments that can lead to aggregate alpha. Professional money managers owned only 10% of U.S. equity shares in the 1950s, so maybe at that time there was a large pool of alpha to exploit.³

By 2007, the percentage had risen to 76%,³ so it’s now hard to fathom how professional funds can deliver alpha in aggregate over the long term going forward. Multiple performance studies from the 1940s to the present have shown that U.S. equity mutual funds as a whole have not delivered enhanced performance versus the stock market, especially after fees.^4-6 There have also been many studies to determine if the future professional winners can be distinguished from the future losers, such as using past performance to pick them. Such studies have also failed to find an indicator to pick the future winners.

One interesting study by Amit Goyal and Sunil Wahal⁷ analyzed the selection and termination of investment management firms by pension plans. Pension funds incorporate an enormous amount of information in making allocation decisions, with due-diligence checklists and support from expert consultants. The Goyal/Wahal study showed that prior to selection, the investment funds showed superior performance, yet were market performers after selection. Of course, the terminated investment funds were underperformers prior to their firing, and market performers afterward.

The implications for investors are clear. Since passive index funds have much lower fees than active managers, holding a portfolio of active managers will likely underperform the market and the appropriate index fund over the long term.

Many times you’ll hear that small cap markets, international and emerging markets are “less efficient”, thus providing ample opportunities for active managers to win. These markets are probably less efficient. Yet, the same aggregate performance logic holds for these asset classes and the evidence from fund performance studies do not show aggregate winning by active managers.

Similar performance studies have been performed with the U.S. bond market.⁸ The logic and results are the same. Among hedge funds and CTAs, performance studies are severely hampered by many biases created by the self-reporting process.⁹ I expect the logic and results to be the same among these funds also.

Another form of evidence are studies performed by academics investigating all sorts of trading rules and security selection approaches based on past historical data. There are thousands of articles like this, some of which are described in the books above.

Many of these articles document the discovery of new anomalies, which can create some controversy if the academic community cannot immediately find a weakness in how the study was conducted. Common weaknesses include data mining issues or studies where risk and/or transaction costs were not properly accounted for.

Some anomalies have withstood the passing of time, so academics incorporate them as new risk factors associated with how securities are priced. Fama and French’s three-factor model¹⁰ incorporated the mounting evidence that small cap and value stocks do indeed outperform the market. The reasonable assumption when incorporated into the commonly accepted asset pricing model is that the small cap and value anomalies actually represent premiums associated with risks that are not fully captured by volatility (or more properly, beta).

This may seem unfair to a portfolio manager who used a value approach to outperform the S&P 500 in the past, but looking forward, the manager now has to compete with low-cost index funds designed with over-weighted exposure to value stocks. That is their new benchmark for performance comparisons.

Implications for Investors

Pretty much nothing in finance can be proven, so we need to rely on common sense and logic. Markets do not have to be 100% efficient to conclude that a buy and hold approach is likely best. Implied in the EMH is that stocks outperform bonds, which outperform cash and inflation over the long term. Once you believe this and accept that considerable losses can occur over the short term, then you’re ready to invest in a diversified portfolio of passive low-fee index funds (such as those managed by Vanguard¹¹). There are a number of good books^12-16 that discuss how to design a passively managed portfolio.

It can be extremely liberating to accept the efficient markets view to managing a retirement portfolio. No more worrying about things you have no control over, and more time to focus on the activities you are passionate about. This is one field where doing less gives you more and hard work doesn’t necessarily pay off.

With respect to financial planning, accepting the efficient markets view allows you to spend more time focusing on the things you can control such as savings and spending rates, modeling liabilities, insurance, and estate planning needs. These are important considerations, whether you’re managing a pension fund or your own personal portfolio. If this stuff doesn’t interest you, then hire a financial advisor to handle the details.

If you want to attempt to beat the market, then spend the time to put together a diversified Vanguard mutual fund portfolio to compare your results to over time. Eventually, you’ll see that this is a great approach to investing, or perhaps you’ll begin to gain evidence of alpha-generation trading skills.

Implications for Asset Class Traders

The markets are definitely not 100% efficient. Yet it’s important to understand the logic and foundations of the efficient markets hypothesis – know thy enemy. Trading edges to be discovered will be hidden in little dark cracks in the foundations of the EMH.

If you’re new to trading, or you want to get better at trading, then you must keep track of your month-to-month performance, and compare the results with a diversified Vanguard mutual fund portfolio. After reading Bogle’s book in the mid-1990s, that is what I did. I figured if I couldn’t beat the Vanguard portfolio over time, then I should devote my talents to something else.

---

References

1. Fama, E., “Efficient Capital Markets: A Review of Theory and Empirical Work”, Journal of Finance, Vol. 25, p. 383-417, 1970.
2. Surowiecki, J., The Wisdom of Crowds, 2004.
3. Fox, J., The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street, 2009, p. 112.
4. Bogle, J.C., Common Sense on Mutual Funds, 2009.
5. Jenson, M, “The Performance of Mutual Funds in the Period 1945-1964”, Journal of Finance, May 1968, p. 414.
6. Carhart, M.M., “On Persistence in Mutual Fund Performance”, Journal of Finance, March 1997, p. 1.
7. Goyal, A. and Wahal, S., “The Selection and Termination of Investment Management Firms by Plan Sponsors”, Journal of Finance, Vol. LXIII, No. 4, August 2008.
8. Lee, M.I., “Is There Skill Among Bond Managers?”, Dimensional Fund Advisors white paper, December 2009.
9. Ilmanen, A., “Expected Returns”, 2011, p. 236-241.
10. Fama, E.F., French, K.R., “The Cross-Section of Expected Stock Returns”, Journal of Finance, Vol. 47, 1992, p. 427-465.
11. Vanguard Funds website: www.vanguard.com
12. Merriman, P.A. and Buck, R., Financial Fitness Forever: 5 Steps to More Money, Less Risk, and More Peace of Mind, 2011.
13. Swedroe, L.E., et al., The Only Guide You’ll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments, 2010.
14. Merriman, P., Live It Up Without Outliving Your Money! Getting the Most From Your Investments in Retirement, 2008.
15. Swenson, D.F., Unconventional Success: A Fundamental Approach to Personal Investment, 2005.
16. Bernstein, W., The Intelligent Asset Allocator: How to Build Your Portfolio to Maximize Returns and Minimize Risk, 2000.