Actively Managing Efficient Markets – 2016/11/26

“Wide diversification is only required when investors do not understand what they are doing.”  – Warren Buffett.

 “The efficient market hypothesis (EMH) is an investment theory that states it is impossible to “beat the market” because market efficiency causes existing prices to incorporate and reflect all relevant information. Thus, assets always trade at their fair value making it impossible for investors to either purchase undervalued assets or sell assets for inflated prices. As such, it should be impossible to outperform the overall market through asset selection or market timing.” – Paraphrase of Investopedia

Warren Buffett bet $1 Million that the S&P 500 would beat the combined returns of any five hedge funds (after fees). The money management firm, Protégé Partners, took Buffett’s bet. We are now three years in and the S&P 500 is up 65.67% compared to 21.87% as of May 2016. After seven years of underperformance, hedge funds have suffered their largest outflows since 2009. Efficient market enthusiasts appear to be winning the debate, but as with many great debates the challenge is in asking the right question. In my view, the question isn’t whether markets are “efficient”. The more practical question is what (mostly) efficient markets mean for retail investors.

Here is why I think EMH advocates should still think critically about their investments. Basically, it comes down to the fact that the same asset can have different values to different investors. This is true primarily because of liquidity premiums, how we define risk, and information & speed asymmetry between sophisticated and retail investors:


Liquidity Premiums

Why pay for liquidity? According to the EMH, more liquid investments should pay a higher return. This is because the higher liquidity allows deep pocketed investors to easily enter and exit positions. Liquidity is often measured as the bid/ask spread. Small investors generally don’t notice this difference in liquidity because it is sometimes less than a cent for the most liquid ETFs compared to a few cents for less liquid ones. A few cents are a big deal for institutional investors like Vanguard because they have to constantly cross the spread (buy and sell positions). However, longer term investors that buy and hold the most liquid investments are paying for that liquidity (in theory) even though they generally are not using it.

There are advantages to being small. Another measure of liquidity is the depth of a market. Institutional investors are often restricted from smaller markets because their actions have a material influence on prices. For example, Warren Buffett no longer trades in tiny companies because if he started buying the stock the price would start to rise. Likewise, if he ever wanted to exit the position the price would fall. Thus, according to the EMH, smaller companies and small markets for alternative investments should pay a higher return.


Definition of Risk

What is risk? According to the EMH investment risks are “priced in” to assets. However, little attention is given to how risk is defined. In practice, “risk” according to large institutional investor looking to justify their salary each quarter means something very different than to an individual with a 10 year time horizon. Because of their size, institutional investors get a much bigger say in how “risk” is defined because their dollars have a larger influence on asset prices.

Money managers, like corporate CEOs, are rewarded for short run and easily quantifiable results. As a result, risks that are easily measured are given a premium compared to risks that are more qualitative in nature. This is why rating agency upgrades/downgrades impact stock prices. Hedge funds are also increasingly using computer algorithms and high frequency trading to drive returns. Both trends emphasize the use of quantifiable information and short term trading strategies. This “short-termism” has worked its way deep into the plumbing of finance. The most important result of this is the way financiers and investors measure risk.

The Sharpe Ratio (below) is perhaps the most important ratio used to measure the performance of a money manager. This ratio is supposed to measure risk-adjusted return by dividing excess return by volatility (i.e. standard deviation). The importance of risk adjusted returns became obvious after the Dot-Com bubble burst as many hedge funds that had simply been making leveraged bets on the stock market went bust. Obviously, a money manager should not get credit for doubling returns by simply doubling their leverage. Thus, attempting to “risk adjust” returns is a step in the right direction.

Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return

For banks, corporates, hedge funds, and other short term oriented investors this definition of risk makes a lot of practical sense. Those with highly leveraged positions (ex. Banks) could get wiped out by sudden moves in markets so managing volatility through the use of VAR models is actually quite crucial. Corporates may have short term liabilities that they need to cover and so suffering a short term loss could potentially threaten bankruptcy. Hedge funds are pressured to achieve high returns each quarter or else their clients start to leave (as they have in droves this year).

However, for regular folks with a long time horizon, risk does not equal volatility. In the words of Warren Buffett, the true measure of risk is the probability of a permanent loss of capital. Two examples should suffice. Long Term Capital Management was considered, for a time, to be a huge success. As documented in “When Genius Failed”, their success was in large part attributed to their exceedingly high Sharpe ratio of 4.35, indicating that they were beating the S&P 500 by 4.35 times after adjusting for return volatility. However, the Sharpe ratio failed to factor in the incredible amount of leverage involved in their strategy (30-50 times). A similar story can be said of AIG, although their approach was arguably less sophisticated as they essentially just sold tens of billions of dollars’ worth of insurance against mortgage default. This strategy also provided very good risk adjusted performance, as measured by the Sharpe ratio, until the housing market began to collapse.

Risk = Probability of permanent loss of capital ≠ Volatility

The EMH states that risk is “priced in” to assets. While this statement may be “correct” it ignores the complexity involved in defining risk, and the diversity of investors in the market. Prices are largely determined by those who put a premium on investments that have low volatility and place less weight on qualitative information that has longer term implications. Smaller retail investors with many years to go before retirement are not subject to the same incentives and constraints. Thus, if the EMH is correct, retail investors should be able to improve returns by investing in assets that have higher volatility, but better long term prospects.


Information & Speed Asymmetry

Market prices can be “efficient” from the point of view of sophisticated investors, but not retail investors. The reason is that sophisticated investors, the way I define them, enjoy better information and act more quickly on that information than retail investors.

Quantitative easing provides a clear illustration of this. In my previous observation on the “Only Game In Town” I pointed out that bond and stock prices were highly correlated with the amount of quantitative easing from the largest central banks. Why would they not be? When the largest central banks signal a continuation of further “liquidity” via QE, they give asset managers an irresistible incentive to pile into the assets that they know central banks will buy at any price. As a result, while CB liquidity is up, bond and stock prices go up as well. The country of origin matters, but only to some extent. We live in a global market, so when the price of one financial asset goes up, it has a positive effect on the price of related financial assets.

When quantitative easing stops it will, in my view, send investors running for the exits. However, until then it is perfectly rational for investors to “front run” central bank bond purchases, even at negative yields. Italian government bonds are trading at 1.83% higher than German bonds. Is this price “efficient”? To a sophisticated investor with teams of analysts and hundreds of algorithms set up to get out at the slightest hint of tapering or Euro collapse…yes! To everyone else…no way!

The EMH ignores obvious differences in the information and speed asymmetry between sophisticated and retail investors. These asymmetries can materially reduce tail risk for those that can get out quickly when the going gets rough. This is a game that retail investors cannot win…but it is one that retail investors can avoid playing all together.


Law of Conservation of Alpha

Before fees, the performance of the average active investor will always equal that of the average passive investor. After fees, active investors will necessarily underperform passive investors. This is the Law of Conservation of Alpha, attributable to William Sharpe. This is true because, by definition, because active investors only trade with each other. There are three key implications of this law:

  1. To EMH advocates, pointing out that active investors typically do about as well or worse than passive investors is not so much an argument for passive investing as it is a recognition that active investors are by definition trading with themselves.
  2. To retail investors, one should avoid making short term changes in investments unless they feel they know more than the average investor in that market. This means one should either spend a great deal of time developing an expertise in a particular niche strategy/market, or avoid active investing altogether.

To all investors, even if you choose to be a passive investor, you still need to choose where to invest. There is no true “default portfolio”. The closest thing we have to a “default portfolio” is the index card (below – Vanguard target 20XX). However, as I (and more importantly the much smarter people I have been citing) have been pointing out…when everyone seems to think a particular investment strategy is a good idea, that strategy tends to get so overbought that it becomes exceedingly risky (ex. Tech stocks 1995-2000 & Housing 2000-2007).

Source: University of Chicago professor Harold Pollack

When choosing this “default portfolio”, understanding liquidity premiums, definitions of risk, and information & speed asymmetry become exceedingly useful. This should be true regardless of whether one believes markets are “efficient”. For the record, I put myself (mostly) in this category, but as I’ve tried to illustrate, this hardly gives retail investors an excuse not to think critically about their investments.


Feel free to share your own thoughts on the efficient market hypothesis. There is no better compliment you can give us than your thoughtful criticism. You can reach us at, or follow us on Twitter @intuitecon


IntuitEcon Team

Disclaimer: These are our personal views. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Our hope is that these observations will merely help you to more critically examine your own beliefs about finance and stimulate dialogue.

4 thoughts on “Actively Managing Efficient Markets – 2016/11/26

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