Efficient Markets Hypothesis Foundations

iStock_000044400072_FullIn a previous blog I discussed the efficient market hypothesis (EMH), which can be summed up with the following statement by recent Nobel Prize winner Eugene Fama.

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

I presented the following three arguments in favor of pragmatically adopting an efficient markets view when investing.

  • The logic of hyper-competition in a fair trading arena – any trading edge will quickly attract competition and be arbitraged away.
  • The mathematical fact that investors as a whole cannot beat the market, and since professional investors manage the majority of assets, aggregate professional alpha must be close to zero before fees.
  • While acknowledging that there can be long-term skilled winners, the empirical evidence suggests it’s very difficult to distinguish luck and skill when evaluating past performance, even when judging your own trading ability.

In this blog I’ll go one level deeper to discuss the fundamental foundations for an efficient market. Why review these? Mainly to develop a better understanding of “the enemy,” and to identify weaknesses in the EMH assumptions that may lead to trading edges. Rather than argue about whether a market is efficient, let’s search for nuanced moments in time and securities-space when the EMH assumptions may not hold – leading to an exploitable trading edge for us. (more…)

Asset Class or Trading Strategy? 

Liquid alternative funds are the new hip product sold by investment management companies. Liquid alt funds offer strategies that have been used by hedge funds, managed futures funds and private partnerships for many years with the potential to earn a higher risk-adjusted return than stocks and bonds often combined with a low correlation. Previously this space was largely off limits to small investors due to institutional-sized minimums or the need to be an accredited investor. Now these strategies are accessible to all investors via ETF and open-ended fund structures, which offer daily liquidity.

The trend towards liquid alt funds is motivated by the desire for enhanced portfolio diversification and the need to do something about low bond yields. These were the same motivations that led to the massive growth of hedge fund assets over the past 10 years as pension funds allocated to this space following the 2000 to 2002 bear market.
(more…)

Efficient Markets

iStock_000038631732_XSmallThe 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? (more…)

Trading Asset Classes  

stockbonds1

I gravitated to asset classes fairly quickly when I first started trading. I had a 60 hour/week engineering job, and didn’t have the time to perform any kind of individual security analysis or sort through hundreds of individual stock charts each day. There were substantially fewer asset classes to keep track of, and that was manageable for me. This was in the early 1990s before ETFs were available, so I used individual mutual funds.

Most practitioners in the field define asset classes very broadly, such as stocks, bonds and cash. From these broad asset classes, there are sub-asset categories among stocks and bonds. For instance, Ned Davis Research1 divides the U.S. stock market into nine stock sectors and about a 100 industry groups. Morningstar splits stocks into nine style boxes with growth versus value on one axis, and small versus large capitalization stocks on the other. (more…)

Finding an Edge 

findingedge

What is the goal of trading and active portfolio management? It’s not just to make money or to get rich. The goal is to generate wealth for yourself and/or your clients at an above-average risk-adjusted return.

With respect to trading and investing, there are two major markets used for wealth creation – the stock market and the bond market. Each market represents an arena where thousands, or even millions, of competitors battle to enhance returns.

Figure 1 shows the annualized returns for U.S. stocks, bonds, T-bills (as a benchmark for cash) and inflation since 1926.1 The annualized standard deviation of returns is used as a measure of risk (there are many other risk measures to choose from).

(more…)