• Log in
• Register free
• Subscribe
• Help
• Tour & Trial IC Advantage

In defence of efficient markets

Created:

26 June 2009

Written by:

Chris Dillow

The efficient markets hypothesis (EMH) is getting a bad press. James Montier of Societe Generale says it is "dead" and "irrelevant" (see his recent Nine rules for value investors) and should be put in the dustbin of history. And a recent survey of members of the Chartered Financial Analyst Institute found that most of them don't believe that prices reflect all available information.

It's time, then, to if not defend the EMH, to at least retrieve what's reasonable about it. To do so, let's be clear on three points.

1. The EMH is not the rational investor hypothesis. The notion that investors are rational could only be believed by someone who never set foot outside their house. But the EMH doesn't require that all investors be rational. It merely says that under certain conditions, enough investors are sufficiently rational to offset others' stupidity.

A key condition here is that it be possible for investors to sell assets short. But in many cases, this condition isn't met. It's often very hard to short sell the assets held by investment trusts. This allows investment trust prices to remain at big discounts to their net asset value.

Equally, there was no active market in many mortgage derivatives, which languished on banks books without being traded, or were sold over-the-counter. Short-selling of these was therefore impossible. Where there's no market, there can be no efficient market.

And during the tech bubble, the huge volatility of tech stocks made short-selling of them very dangerous, where it was possible at all. That allowed them to become over-priced.

Indeed, it's often risky to sell assets short. Even if you're right that it's over-priced, the irrational investors who cased it to be over-priced can drive it even higher.

Now, in the case of individual shares, you can sometimes reduce this risk by pairs trading. For example, if you think (say) BP is over-priced you can short-sell it and go long of Royal Dutch. This would allow you to benefit from any irrational sentiment which drives up the oil majors generally.

However, in the case of whole asset classes, such as housing or share indices, no such hedge is possible. As a result, says Bernard Dumas of the University of Lausanne, rational investors will be unable to do much about excess volatility - it's just to risky to go against a herd that's over-reacting. This in turn means that, as Yale University's Robert Shiller has said, stock markets will be "micro efficient but macro inefficient." Micro efficient, insofar as it's possible to short-sell particular stocks , but macro inefficient because it's harder to short sell whole indices.

In this context, the ubiquity of asset price bubbles might be evidence that investors are irrational. But it is not so much evidence against the EMH as evidence that a necessary precondition for efficient markets - the ease of short selling - is lacking.

2. The EMH says returns are a reward for taking risk. But we must be clear what risk is.

It used to be thought that risk was simply volatility - standard deviation. This is too simple.

For example, Mr Montier points out that, over the long-run, value stocks have out-performed the market despite their lower volatility. However, if value stocks carry a risk that can't be measured by volatility, then it's possible that their good returns aren't evidence of them having been under-priced - and hence evidence against the EMH.

The likeliest candidate here is that value stocks carry macroeconomic risk - the danger that they'll do really badly in a recession. Measuring recession risk accurately is tricky; stocks can fall before the actual recession or even because of fears of a recession that doesn't materialize. Two things, though, suggest value stocks do carry recession risk. First, Fidelity's special situations fund, whilst Anthony Bolton was managing it, was highly correlated with retail sales growth; it did badly when high street sales did. This suggests that the UK's most successful fund manager thrived, in part at least, by taking on cyclical risk. And secondly, my value portfolio - the 20 highest yielders in the FTSE 350 - did horribly during the worst of the credit crisis, falling by 55.2 per cent between end-August and end-December last year, against the FTSE 350's 22.8 per cent fall.

And market risk, volatility and cyclical risk are only a few risks. There's also correlation risk, tail risk, counterparty risk, liquidity risk and so on. If we ignore these risks, it'll look as if lots of assets are under-priced. But that tells us not that the EMH is wrong, but that our understanding of risk is inadequate.

3. The central message of the EMH is that there's no money left on the table. There rarely is.

Critics of the EMH have often pointed to anomalies. But these have often disappeared soon afterwards. For example, in the early 1980s, economists noted that small cap stocks had done well for years. But in the following years they badly under-performed. A similar thing might have happened to the loser stocks identified by US academics Werner de Bondt and Richard Thaler in the mid-80s.

In this context, Mr Montier raises a puzzle. He points out that fund managers' best stock ideas usually out-perform. That suggests - contrary to the EMH - that many stocks might be mispriced. But this doesn't cause fund managers to beat the market, because they hold many more shares, which dilutes their performance.

This raises the question. If the market is so inefficient, you'd expect investors who aren't constrained by the need to over-diversify to be able to make money. But where are they? According to research group HFRX equity market neutral hedge funds have made almost no money at all for their investors over the last six years. And whilst there's some evidence that private investors can beat professional ones, but the out-performance is small.

Yes, you only have to look around you to see than investors are irrational. But equally, you only have to look around you to see that very few people get rich by beating the market. Most of the people who attack the EMH work for a living. That tells us something.

Which brings me to the virtue of the EMH. Granted, this is not 100 per cent true even in the narrow way I've construed it; the good performance of momentum and low-risk strategies is perhaps the best evidence against it. But the EMH is a good prejudice to have, as it warns us that there's no easy money to be made, and to look for hidden risks.

If banks had had this prejudice a few years ago, they'd not have believed that some allegedly AAA-rated securities could offer good returns, so they'd have been more sceptical of mortgage derivatives. Belief in the EMH, then, can save us a lot of trouble.

• Share Tips
• Trading
• Companies
• Markets and Sectors
  • Markets
  • Sectors
• Columnists
• Stock Screens
• Funds Data
• Research Tools
• Investment guides
• Events
• Q and A

requires IC Advantage

---

Subscribe today

Celebrate our 150th anniversary with fantastic savings on a joint magazine and IC Advantage subscription.

Subscribe today and save £150