Thursday, June 25, 2009

Insight: Efficient markets theory is dead

The efficient markets hypothesis, or EMH, is the financial equivalent of Monty Python’s dead parrot. No matter how much you point out that it is dead, the believers simply state that it is just resting. In part this is testament to the high degree of inertia that academic theories enjoy. Once a theory has been accepted it seems to take forever to dislodge it. As Max Planck observed: “Science advances one funeral at a time.”

The EMH states that all information is reflected in current prices. It is bad enough that the EMH exists as an academic theory (filling student’s heads with utter garbage) but the very real damage it does comes from the fact that as Keynes opined “practical men are usually the slaves of some defunct economist”. The EMH has left us with a long litany of bad ideas that have influenced the very structure of our industry.

For instance, the capital asset pricing model (son of EMH) has left us obsessed with performance measurement. The separation of alpha and beta is at best an irrelevance and at worst a serious distraction from the true nature of investment. Sir John Templeton said it best when he observed that “the aim of investment is maximum real total returns after tax”. Yet instead of focusing on this target, we have spawned an industry (the consultants) that only pigeon-holes investors into categories.

The obsession with benchmarking also gives rise to one of the biggest sources of bias in our industry – career risk. For a benchmarked investor, risk is measured as tracking error. This gives rise to Homo Ovinus – a species concerned purely with where they stand relative to the rest of the crowd. This species is the living embodiment of Keynes’ edict that “it is better for reputation to fail conventionally than to succeed unconventionally”.

The EMH also lies at the heart of risk management, option pricing theory, the concept of shareholder value, and even the regulatory approach (markets know best), all of which have inflicted serious damage on investors.

However, the most insidious aspect of the EMH is the advice it offers as to the sources of outperformance. This may sound oxymoronic but the EMH is actually very clear on how you can outperform. You either need inside information, which is, of course, illegal. Or, you need to forecast the future better than everyone else. There isn’t a scrap of evidence to suggest that we can actually see the future at all. The desire to out-forecast everyone else has sent the investment industry on a wild goose chase for decades.

EMH also tells us that opportunities will be fleeting. Why? Because smart, rational arbitrageurs will eradicate any opportunities swiftly. This is akin to the age-old joke about the economist and his friend walking along the street. The friend points out a $100 bill lying on the pavement. The economist says: “It isn’t really there because if it were someone would have already picked it up.” This mindset encourages investors to focus on the short term (where the opportunities lie according to EMH), rather than on the long term (where the true informational advantage is likely to lie).

EMH fails dramatically when presented with the real world. The most damning evidence against the EMH scarcely merits discussion in academic circles. The elephant in the room for EMH is the existence of bubbles. So terrified are academics of bubbles that they go to enormous lengths to justify them. Believe it or not, two economists have even written a paper arguing that the Nasdaq was not actually a bubble when the composite index rose above 5,000 at the start of this decade.

Fund management firm GMO defines a bubble as at least a two standard deviation move from (real) trend. Under EMH, two standard deviation events should occur roughly every 44 years. However, GMO found some 30 plus bubbles since 1925 – slightly more than one every three years. While the details and technicalities of each episode are different, the underlying dynamics follow a very similar pattern. Ex-ante diagnosis of bubbles is surely the fatal blow to EMH.

Faced with this damning assault, EMH supporters fall back on what they call their “nuclear bomb”, the failure of active management to outperform the index. However, if fund managers are all trying to out-forecast each other, it is no wonder that they do not outperform. New research shows that career risk (losing your job) and business risk (losing funds under management) are the prime drivers of most professional investors. They do not even try to outperform.

Surely, it is high time to consign EMH and its legacy to the dustbin. Will we manage it? I’m a pessimist. As JK Galbraith said financial markets are characterised by “extreme brevity of financial memory . . . there can be few fields of human endeavour in which history counts for so little as in the world of finance”.

James Montier is global strategist at Société Générale. His new book “Value Investing” will be published in October by Wiley.