Over the years I’ve swatted away lots of arguments against the Efficient Markets Hypothesis. The question is not whether the EMH is “true,” how could it be? Almost no economic model is precisely true. The question is whether it is useful. I find the EMH useful, and anti-EMH models to be almost completely worthless. I’m still looking for the model that will tell me how to beat the stock market. Just when I was starting to warm up to Shiller’s model, he missed the huge bull market of 2009-11.
Lots of academics in finance departments think you test the EMH by looking for market anomalies. Yet even if the EMH were completely true, there should be millions of anomalies out there—roughly one million for each 20 million data correlations that one examines. So that can’t be right.
A better idea is to see if there is evidence that others have found anomalies that are “real,” i.e. not just coincidence. The way to test that is to see if other people have discovered actual market inefficiencies, i.e. if excess returns are serially correlated. Yet studies show that if there are persistent excess returns to better than average mutual funds, the gains are so small, and so hard to spot, that this fact is virtually useless to the average investor.
The last stand of the anti-EMH crowd (in my comment sections) was to point to hedge funds. They argued that only dopes invest in mutual funds, and that all the smart money goes into hedge funds, which are in turn managed by the smart stock pickers. And they argued that hedge funds consistently earned above average rates of return, at least in aggregate, and over an extended period of time. Now it looks like even that isn’t true:
There is no doubt that hedge-fund managers have been good at making money for themselves. Many of America’s recently minted billionaires grew rich from hedge clippings. But as a new book* by Simon Lack, who spent many years studying hedge funds at JPMorgan, points out, it is hard to think of any clients that have become rich by investing in hedge funds (whereas Warren Buffett has made millionaires of many of his original investors). Indeed, since 1998, the effective return to hedge-fund clients has only been 2.1% a year, half the return they could have achieved by investing in boring old Treasury bills.
I’ve done much better than that investing on my own. And then there’s this:
How can that be, when traditional performance measures for the industry show average returns of 7% or so? The problem is a familiar one in fund management and is the equivalent of the “winner’s curse” that occurs with auctions (the successful bidder is doomed to overpay). Take a whole bunch of fund managers and give them an equal amount of money to invest. The managers that perform best initially will tend to attract more investors, and so will gradually become bigger than the moderate or poor performers (who will eventually go out of business).
But the manager will not perform well indefinitely. By the time a bad year occurs, the manager will be running a much larger fund. In cash terms, the loss on the expanded fund may easily outweigh the gains made when the fund was smaller. The return of the average investor will be lower than the average return of the fund.
What is true for individual funds also turns out to be true for the industry as a whole. Between 1998 and 2003 the average hedge fund earned positive returns every year, ranging from 5% in 2002 to 27% in 1999. Back then, however, the industry was quite small: overall assets only passed $200 billion in 2000.
That strong performance attracted the attention of pension funds, charities and university endowments at a time when their portfolios had been clobbered by the bursting of the dotcom bubble. They duly piled into “alternative assets” like hedge funds and private equity. By early 2008 the hedge-fund industry had around $2 trillion under management.
But that year turned out to be the annus horribilis for the hedge-fund sector. The average performance was a loss of 23%. In cash terms the loss for that single year was more than double the industry’s total assets under management in 2000, when it was still doing well. Mr Lack reckons that the industry may have lost enough money in 2008 to cancel out all the profits it made in the previous ten years.
One of my least favorite maxims is; “the market can stay irrational longer than you can stay solvent.” I consider that to be a cop out for losers. If the market is actually irrational, you set up a long term investment strategy to take advantage of that inefficiency. You don’t gamble everything on one role of the dice. There should be “anti-EMH” mutual funds that invest on the assumption of market inefficiency, and these should tend to earn above normal rates of return on long term investments.
The past five years should have been an absolute gold mine for the anti-EMH types that supposedly dominates the hedge fund industry. Just think about it. Shiller says stocks are way too volatile, and the US stock market has been incredibly volatile since 2007. No need to worry about the market staying irrational for too long, the long run adjustments occurred quite rapidly. Then we had the mother of all housing bubbles in 2006, another great opportunity for people to rake in profits from market inefficiency. The year 2008 should have seen extraordinary profits to the hedge fund industry, with all that “irrationality” being corrected. Instead they lost more than they’d made over the previous decade.
One guy did beat the market by betting the housing bubble would collapse, but I recently read that he’s been doing poorly ever since. And we all know about the unfortunate stock market call by Mr. Roubini in 2009.
The anti-EMH crowd needs to face facts. Even the smart money can’t beat the market, except by luck.
What is there not to like about the EMH? It’s an aesthetically beautiful theory. It’s survived every test thrown at it. And yet almost everyone thinks it’s wrong. All the really cool, smart, contrarian bloggers ought to love the EMH. I don’t get it. Maybe intellectuals are put off by a theory that implies that the rabble are (collectively) smarter than they are. But that’s not the right way to look at things. The rabble all oppose the EMH. Go to a bar and start talking to the first drunk you meet. I guarantee he will have an opinion on where markets are going. I guarantee he won’t say “predictions are impossible because all publicly available information is already incorporated into asset prices.” Who are you with; him or me?
PS. Many pundits claim the housing bubble shows the EMH is false. This post shows why they are wrong.
PPS. Many people claim that wild speculative bubble always lead to crashes. This academic study shows that’s not true:
Abstract. The collapse of an investment mania usually reminds people that the phrase “This time is different” is dangerous. Recollections of this mantra then typically either state outright or at least imply that “It is never different.” However, there is at least one counterexample to this cautious view, a giant and wildly speculative investment episode that was profitable for investors. The British railway mania of the 1830s involved real capital investment comparable, as a fraction of GDP, to about $2 trillion for the U.S. today. It faced withering skepticism and criticism, much of it very reasonable, as its supposedly rosy prospects were based on extrapolation from the brief experience of just a couple of successful early railways. Yet by the mid-1840s, it was seen as a great investment success.
The example of the railway mania of the 1830s serves as a useful antidote to claims that bubbles are easy to detect or that all large and quick jumps in asset valuations are irrational.
Of course there were many countries that had housing “bubbles” in 2000-06, where prices never collapsed.