Are Markets Efficient?

Are markets efficient?

A finance professor and his student were walking across campus when they spotted a $20 bill on the ground. The professor advised, “Don’t bother picking that up. If it was real, someone would’ve picked it up already.” The student picks it up anyways and buys himself to a beer.

There are not a lot of $20 bills laying on the ground, but they are found from time to time. That’s the short answer. The long answer is as follows:

The term efficiency is used to connote several different ideas, but the most common one is a concept formalized into the Efficient Markets Hypothesis (EMH) by Eugene Fama, who won a Nobel prize for his work on the subject. The theory basically says that markets allocate capital best and thus value assets best (or “efficiently”). There are 3 forms of the theory:

  • Weak Form: all historical information is priced into an asset’s price.
  • Semi-Strong Form: all historical and public information is incorporated into an asset’s price.
  • Strong Form: all historical, public, and non-public information is Incorporated into an asset’s price.

However, below are some instances when when each of the forms does not hold up.

Strong Form

  • Prices often have material and sustained moves when private information is publicized.
    • Prices often move on earnings announcements or press releases.
    • The uncovering of scandals or fraud impacts prices.
  • I do not know anyone that subscribes to the strong form of the EMH.

Semi-Strong Form

  • Arbitrage opportunities exist fairly frequently. Although not all are actionable due to constraints and costs, enough are:
    • Closed-end funds can trade at extreme premiums and discounts to their underlying NAV.
    • We have seen public companies trading for less than the value of their stakes in other public companies.

Weak Form:

  • Momentum as a risk factor has been shown to offer a return premium.
  • Flash crashes and flash rallies have extreme mean reverting tendencies.

Beyond poking holes in the idea of market efficiency, the above examples represent opportunities for active managers to outperform. Yet, it is difficult for investors to outperform on a consistent basis, which implies (but does not prove) that markets are at least somewhat efficient.

So what can we conclude? That markets are not always efficient, but are probably efficient at least some of the time. This is a very unsatisfying answer, but that is okay because it is unclear whether market efficiency even matters to investors. I’ll explain why in an upcoming post.

P.S. My own view is that markets are generally efficient, although this cannot be proven. I could’ve listed more examples of market inefficiency, but they would not have been robust enough to categorically prove markets are inefficient and stand up to every possible logical critique. On the other hand, data showing that markets are difficult to beat does not prove markets are efficient, but it seems like investors would beat the markets more easily, frequently, and consistently if markets were generally inefficient.

Thus, I believe markets are generally efficient. However, efficiency seems non-existent during certain times (ie. when rationality gets thrown out the window during bubbles and panics) and in specific asset classes (where there are constraints to arbitrage, complexity, due diligence costs, transaction costs, or anything else that makes it difficult to invest easily). So my usual answer to the original question is that markets are generally efficient, but there are episodes and pockets of inefficiency.

Weekend Reads

My best reads of the week:

Active Management Find Favor in Fixed-Income (Institutional Investor)

The Happiness Spending Threshold And What It Really Means To Live Within Your Means (Nerds Eye View)

Some Lessons I Learned from the Dotcom Bubble for the Coming Crypto Bubble (Continuations)

Behind the Scenes at Orchard Platform, a Struggle to Innovate (New York Times)

Mary Meeker’s 2017 internet trends report: All the slides, plus analysis (recode)

Why “Gig Health” Matters (Financial Times)

The Advantage Of Being A Little Underemployed (Collaborative Fund)

Taking to task an industry that bets on children’s lives for an easy profit (Washington Post)

The Work You Do, the Person You Are (New Yorker)

The Curious Case of the Disappearing Nuts (Outside) and Trouble at the top of the world: Bodies recovered at Everest and complaints of stolen oxygen (Washington Post)

Infographic: The Properties of Money

Courtesy of: The Money Project

Market Efficiency, Indexing, and Low Cost Investing vs Active Management

Part of the reason I write is to articulate various frameworks and positions that are in my head. Many people ask me similar questions too, so hopefully I can just refer them to the blog in the future. That being said, I’m going to kick-off a multi-post series on the oft-misunderstood concepts of market efficiency, low-cost investing, index investing and passive management.

Despite the growing popularity of index investing (which I highlighted last week):

  • Active managers still manage the majority of assets under management (AUM).
  • Many investors’ think that they or someone they hire can beat the market.

On the flip side:

  • Many investors’ conflate market efficiency, indexing, low-cost investing, and a host of other concepts.
  • Many passive investors overstate the case for market efficiency and/or index funds.
  • Some investors have a blind faith in market efficiency and/or passive management.

Adding to (or abetting) the confusion is a financial services industry that markets and promotes a wide range of approaches. It can be difficult to find unbiased answers and construct a framework without researching these topics yourself. My goal for the next few posts is to provide some answers in a concise way.

Weekend Reads

A diverse set of reads for the long weekend:

Cutting Off Your Nose to Spite Your Face (Abnormal Returns)

The Psychopath in the Corner Office (Institutional Investor)

Only Robots Can Tally What the Largest US Pension Fund Pays in Fees (Wall Street Journal)

Alone on the Open Road: Truckers Feel Like ‘Throwaway People’ (New York Times)

Veteran big game hunter dies after elephant, felled by gunfire, collapses on him (Washington Post)

Twitter has ‘kicked around’ the idea of offering a premium subscription service (ReCode)

Earlier this week:

Watching the Migration to Index Funds (Thoughtful Finance)

Watching the Migration to Index Funds

Fund flow data consistently shows that dollars have been moving from actively-managed funds to passively-managed funds over the past decade. Beyond seeing the data every quarter, the shift has been evident in the conversations that I have.

Ten years ago, most of the clients that I spoke to were skeptical of index mutual funds and ETFs. I’d have to explain the rationale and evidence supporting index funds.

Five years ago, it was a toss-up whether new client conversations would be spent explaining why we primarily used index funds or explaining why we also had exposure to some higher cost active funds.

These days, new clients are often quick to understand and accept the indexed parts of portfolio recommendations, but I have to explain why specific active funds make more sense for parts of a portfolio.

Although index funds are not always best and certainly not for all parts of a portfolio, they often are the best choice and rarely a terrible choice. Thus, I think greater investor awareness and acceptance of index funds is generally a good thing. It’s been interesting to watch the migration.

Weekend Reads

Seems like the NYT, WSJ, or WaPo broke a major news story every evening this week. Here’s some non-Trump/Russia/Comey reads for your weekend reading:

“On average, only people who make $150,000 a year or more say they value doing work that is important to them. Everyone else prioritizes an income that is stable and secure. Yet fewer than half of Americans earn a stable amount every month.” -Shift Commission

Findings of Shift: The Commission on Work, Workers, and Technology (Shift Commission)

State Unemployment Rates by Race and Ethnicity Show Recovery Expanding But Still Leaving Stubborn Pockets of High Unemployment (Economic Policy Institute)

How Homeownership Became the Engine of American Inequality (New York Times)

US Household Debt Surpasses Pre-Crisis Peak (Financial Times) VERSUS Are Household and Student Debt Exploding? (FRED blog)

Consumers Place Personal Loans Stop The Credit Mountain (Transunion)

Venezuelan Riot Police Seek Way Out (Wall Street Journal)

A Day in the Life of Americans (Flowing Data) (this page is way cooler on a non-phone screen)

Peter Thiel on Competition

Over the past few weeks, I have seen and heard evidence of increased competition in both public and private credit markets. As valuations rise and prospective returns decline, I think it wise to remember Thiel’s mantra of avoiding competition. Just as businesses do best in the absence of competitors, investors perform best when they do not have to compete for opportunities.

“Competition means no profits for anybody, no meaningful differentiation, and a struggle for survival. So why do people believe that competition is healthy? The answer is that competition is not just an economic concept or a simple inconvenience that individuals and companies must deal with in the marketplace. More than anything else, competition is an ideology—the ideology—that pervades our society and distorts our thinking. We preach competition, internalize its necessity, and enact its commandments; and as a result, we trap ourselves within it—even though the more we compete, the less we gain… If you can recognize competition as a destructive force instead of a sign of value, you’re already more sane than most.

-Peter Thiel, Zero to One

Brilliance vs Rationality

Just now catching up on highlights from last week’s Berkshire Hathaway annual meeting, which is always full of wit and wisdom from Buffett and Munger. The above quote is my favorite from this year’s meeting and is pretty consistent with what Munger and Buffett have been saying for years about the importance of intelligence versus sober thinking.

On IQ:

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” -Warren Buffett (via Wiley)

 

“Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” -Warren Buffett (via Pensions & Investments Online)

On Rationality:

“It is remarkable how much long-term advantage people like [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger (via 25iq)

Lastly, one of my favorite Munger stories (via WSJ):

“In the late 1980s, [Munger] recalled in a magazine interview, a guest at a dinner party asked him, “Tell me, what one quality accounts for your enormous success?”

Mr. Munger’s reply: “I’m rational. That’s the answer. I’m rational.”

 

If rates are going up, why invest in bonds?

Someone recently asked, “If rates are going up, why invest in bonds?”

The short answer is because the yield may more than compensate you for the interest rate risk that you are taking.

The longer answer is that the question itself is problematic:

  • Firstly, this common question rarely indicates which rates are going up. Overnight rates (like the headline Fed Funds rate) or long-term rates (like the benchmark 10-year Treasury)?
  • The question also pre-supposes that anyone knows whether rates are going up or down. If anyone knew the direction of specific rates with certainty, they could retire by tomorrow.
  • Even if someone did know that a specific rate was going up, they wouldn’t know how much the rate was going to change or over what timeframe.

All of the above relate to simple Treasury bonds and do not even touch on any form of credit, the shape of the yield curve, or larger questions like asset allocation, diversification, or correlations.

Keep Calm and BTFD

Asset prices are high and fear is low these days. This situation may continue for days, weeks, months, or years; but markets move in cycles. Some day, asset prices will decline. Investors will panic and drive markets even lower. Fear will paralyze investors. Even the deep value investors will be hesitant to buy assets below their intrinsic value, due to market technicals. When prices are low, it is emotionally difficult to buy. So remember to stay calm and buy the f*cking dip.

h/t @RobinWigg