Not all assets are classes

Asset allocation used to be easy. There were three main asset classes investors had to contend with: cash, bonds, and equities.Viewing the remainder of this article requires a Subscription

Efficient Market Hypothesis – News of it’s death might be premature

I’ve been reading countless attacks on the efficient market hypothesis, CAPM, and all the related derivativations that have come out of the ideas of rational decision makers and optimal pricing. The attacks vary, but seem to center on the current crisis as proof that mispricings occur and that the markets are in fact not efficient. Academia seems to have room now for the next model that will surely explain the previous bubbles, but in time, will also come under attack. Surprisingly, I want to offer a little defense of the tools that have come out of EMH…

As a portfolio manager, and specifically, a value-oriented portfolio manager, let me start by highlighting that I do not believe the markets are efficient. I believe there are opportunities to outperform. I believe that a lot of investors depended too heavily on EMH and got caught up in the theory.

That disclaimer aside, EMH gives investors a framework. Should we depend on it? Definitely not. But EMH gives us the language to discuss averages and some big picture ideas. For example, EMH would tell us that we should expect roughly 50% of the managers to outperform and 50% to underperform in any given time-period (leaving out some nuances of transaction costs and taxes – big nuances, for sure). Managers who now criticize EMH would like the public to believe that we live in Lake Woebegone, where all the children are smarter than average and all the money managers will be better than average. Simple math and logic should show us the fault in that logic.

In a survey of money managers, 85% believed that they were better than average. Let’s look at that statistic a bit more closely. Of the 85%, some will be right and some will be wrong. Of those that are right, some will be able to beat the average on purpose, and some will be able to beat the average by luck. Of the 85%, some will be wrong. We can assume that none will be wrong on purpose. There are also the managers in the 15% who do not believe that they will outperform the average. Some will be right. Some will be wrong, and indeed, perhaps because they know how math works, a higher proportion of them will be able to beat the average that the managers in the 85%. Now we’re really confusing ourselves.

The key question for investors then, is not whether the EMH is right or wrong, it is just a tool. The key question is whether an individual investor can predict which manager will outperform. If an investor believes that they have no predicitive ability, which, let’s face it, most people don’t, then investing in an ETF and subscribing to the EMH is probably a pretty reasonable option. If, however, there are process-oriented factors that grant some money managers a higher probability of outperforming, then investing in that manager can provide a higher expected return.

Some simple ways to outperform – yes, they exist. Let’s say your broker or financial advisor tells you to have a certain portion in stocks (already, this percentage probably came out of some tool based on Monte Carlo simulations and a direct descendent of EMH). Your broker then says to invest in an S&P 500 ETF. There are very simple ways to outperform the S&P 500:

1. Invest in an equal weighted weighted index rather than a cap weighted index.
2. Invest only in the “value” portion of the index, excluding “growth” stocks.
3. Invest in a small cap index instead.

Now your financial advisor or broker probably told you to put some in large cap, some in small cap, some in value, some in growth. In essence, you probably just replicated the market portfolio, and then you should just use a broad based ETF. Instead, investors need to use the tools and research that came out of the EMH, while recognizing their limitations, to make more informed investment decisions.

Montier “…how EMH has damaged our industry” (reprinted with permission)

In this excellent piece from last week, James Montier highlights some flaws in the efficient market hypothesis. More importantly, he outlines the some of the damage – that may take years to repair – caused by the ensuing mentality in the investment community. Beta and alpha debates should move over already. Risk is not volatility. This is a beginning of a trend that I’m seeing of late. The intellectual framework is actually shifting. Consulting firms to big pension funds are reviewing the idea of style boxes. Stagnant asset allocation is being reworked, with emphasis on higher allocations to undervalued assets. Benchmarking is changing. Indexing itself is changing. This piece is a good starting point.

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