Complete Blog 1 - Are the markets inefficient?
Are the markets inefficient?
It was over 3 years ago during Principles and Theories of Finance where the concept of market efficiency was first introduced to me. Learning about that in first year was overwhelming and it was difficult to comprehend the importance of the efficient market hypothesis (EMH) to the Global financial markets. However, now in final year, I have a much greater appreciation for the EMH and understand it is one of the foundation blocks of modern finance and there are many developments in finance which rely on the assumption of market efficiency - one of which I will be conducting for my dissertation, the event study methodology. I may have considered it perhaps sacrilege to question its authenticity during first year, but now I have developed far more scepticism and criticality of these seemingly-perennial theories.
So, what is the EMH? Its roots lay in the work of Maurice Kendal which outlined that share price movements follow a random walk, such that future price movements cannot be predicted by previous price movements. The work concluded that share prices are impacted by 'news' and the sheer nature of news means that it is unknown and unpredictable. Eugene Fama built upon this and we've all had the pleasure of reading finance textbooks outlining the three forms of pricing efficiency, with the semi-strong form being widely accepted in academia. It outlines that investors are rational actors and they cannot beat the market through analysis of information that is publicly available as share prices already reflect all publicly available information. This implies that it is impossible to both sell shares for over-inflated price or to purchase under-priced shares. Thus, the only ways to beat the market are to take on more risk or by chance.
Enter, Warren Buffet and actively managed funds around the world.
Most people are aware of Warren Buffett's story as he is the stereotypical (and frankly rather boring) answer to the 'Who is your Idol?' interview question. Unafraid of sacrilege, Mr. Buffett has been openly critical of the EMH over the years and has been consistently able to outperform the market through 'value investing' (the active investment strategy whereby shares are chosen because they are currently traded for less than their intrinsic or fundamental value). It is not only Warren Buffet who follows this strategy and refutes the EMH, 75% of investors' assets are actively managed, implying that many investors do not correspond with academics and instead feel they can benefit from inefficiencies in the market to improve returns.
Cynical Calum: It is of course expected that active asset managers refute the EMH because they gain fees and commission on the assets under their management. If they were to accept that markets are indeed efficient, the work they carry out would be futile and they would be out of a very well-paid job.
So, given this, why did Warren Buffett raise a bet with a hedge fund stating that a passive Vanguard index fund tracking the S&P 500 would outperform a number of hedge funds over a 10 year period?
Cynical Calum: You'd be forgiven if you thought - similarly to myself - it may have been to augment his omniscient status by investing heavily in the index fund himself, knowing many others would follow suit because they replicate his actions as gospel. However, Mr. Buffett did not invest in this fund at all.
Having removed my cynical hat, what I believe more likely is that Mr. Buffett expected passive index tracking funds to grow in prominence, as a result of the significantly lower fees they charge, ease in portfolio diversification and the expected growth of the general U.S economy following the recession. The large cap companies, comprising the S&P 500 and whose value is intrinsically linked to the health of the U.S economy, would grow and prosper from the economic recovery and thus provide high returns. These returns could not be replicated - or certainly not consistently beaten - by active managers. Active managers have to understand that their services are not always needed; such as post-crisis in 2008 when the general market is returning well.
Thus, what played out was, as expected by the omniscient (I concede, he is...) Mr. Buffett, high demand for the S&P 500 shares because of the low fund fees, and returns which could not be beaten, perpetuated the cycle of investing in these funds, and as a result assets under management by active managers has declined considerably. Subsequently, capital inflows into the market are in index funds, which could have implications for the future.
Has investing in passive funds gone too far?
As outlined above, passive funds have their advantages. It must be said though, as a result of the high demand because of these advantages, coupled with the huge quantitative easing package the Western Governments have delivered over the previous decade facilitating cheap finance, shares in prominent indices like the FTSE100 and S&P 500 are, in my opinion, highly overpriced. Herd behaviour in passive index funds has arguably distorted prices away from their fundamental intrinsic value - the present value of all future cash flows. If you believe my argument, the market is not currently efficient because there is a bubble in the shares within many of these indices - and bubbles cannot exist in a semi-strong form market. However, as Blackrock's paper "Index Investing Supports Vibrant Capital Market" suggests, the scale of index tracking funds are marginal - 7% of assets. While that may be the case now, they are heavily concentrated in the FTSE100 and S&P500 indices. Should inflows into these index funds continue at significant pace, even if you do not believe there is currently a bubble, it would be hard to argue against it in a few years time - providing the market doesn't correct in the mean time.
As we know, in index tracking funds, shares are held based upon their market-cap weighting in a particular index. Potentially, if these funds start dumping shares en-mass perhaps as a result of a change in index weighting or irrational behaviour such as a Minsky moment, their price will decline significantly, again not reflecting their true value. So, although value investing strategies have largely failed in recent years, the bubble may lead to a sort of market alteration which could provide active asset managers with an opportunity to benefit from inefficiency and potentially beat the market through their typical value investing strategy.
Summary
Although I still believe the majority of shares in the majority of markets at the majority of the time are efficiently priced, I understand that it is not infrequent that inefficiencies occur. The fundamental assumption of the EMH, that investors are rational actors, is questionable and this explains the creation of asset bubbles. While it feels strange to be questioning the EMH because of its dogma-like status, I have no doubt the EMH will remain integral to finance for decades to come, and so too will the argument of passive vs active asset management remain a part of investing. Essentially, it is down to the investor and when they see higher returns elsewhere, their current investing method will be questioned regardless.
It was over 3 years ago during Principles and Theories of Finance where the concept of market efficiency was first introduced to me. Learning about that in first year was overwhelming and it was difficult to comprehend the importance of the efficient market hypothesis (EMH) to the Global financial markets. However, now in final year, I have a much greater appreciation for the EMH and understand it is one of the foundation blocks of modern finance and there are many developments in finance which rely on the assumption of market efficiency - one of which I will be conducting for my dissertation, the event study methodology. I may have considered it perhaps sacrilege to question its authenticity during first year, but now I have developed far more scepticism and criticality of these seemingly-perennial theories.
So, what is the EMH? Its roots lay in the work of Maurice Kendal which outlined that share price movements follow a random walk, such that future price movements cannot be predicted by previous price movements. The work concluded that share prices are impacted by 'news' and the sheer nature of news means that it is unknown and unpredictable. Eugene Fama built upon this and we've all had the pleasure of reading finance textbooks outlining the three forms of pricing efficiency, with the semi-strong form being widely accepted in academia. It outlines that investors are rational actors and they cannot beat the market through analysis of information that is publicly available as share prices already reflect all publicly available information. This implies that it is impossible to both sell shares for over-inflated price or to purchase under-priced shares. Thus, the only ways to beat the market are to take on more risk or by chance.
 |
| Hey Warren, nice returns |
 |
| Alright Fam(a), nice nobel prize |
Enter, Warren Buffet and actively managed funds around the world.
Most people are aware of Warren Buffett's story as he is the stereotypical (and frankly rather boring) answer to the 'Who is your Idol?' interview question. Unafraid of sacrilege, Mr. Buffett has been openly critical of the EMH over the years and has been consistently able to outperform the market through 'value investing' (the active investment strategy whereby shares are chosen because they are currently traded for less than their intrinsic or fundamental value). It is not only Warren Buffet who follows this strategy and refutes the EMH, 75% of investors' assets are actively managed, implying that many investors do not correspond with academics and instead feel they can benefit from inefficiencies in the market to improve returns.
Cynical Calum: It is of course expected that active asset managers refute the EMH because they gain fees and commission on the assets under their management. If they were to accept that markets are indeed efficient, the work they carry out would be futile and they would be out of a very well-paid job.
So, given this, why did Warren Buffett raise a bet with a hedge fund stating that a passive Vanguard index fund tracking the S&P 500 would outperform a number of hedge funds over a 10 year period?
Cynical Calum: You'd be forgiven if you thought - similarly to myself - it may have been to augment his omniscient status by investing heavily in the index fund himself, knowing many others would follow suit because they replicate his actions as gospel. However, Mr. Buffett did not invest in this fund at all.
Having removed my cynical hat, what I believe more likely is that Mr. Buffett expected passive index tracking funds to grow in prominence, as a result of the significantly lower fees they charge, ease in portfolio diversification and the expected growth of the general U.S economy following the recession. The large cap companies, comprising the S&P 500 and whose value is intrinsically linked to the health of the U.S economy, would grow and prosper from the economic recovery and thus provide high returns. These returns could not be replicated - or certainly not consistently beaten - by active managers. Active managers have to understand that their services are not always needed; such as post-crisis in 2008 when the general market is returning well.
Thus, what played out was, as expected by the omniscient (I concede, he is...) Mr. Buffett, high demand for the S&P 500 shares because of the low fund fees, and returns which could not be beaten, perpetuated the cycle of investing in these funds, and as a result assets under management by active managers has declined considerably. Subsequently, capital inflows into the market are in index funds, which could have implications for the future.
Has investing in passive funds gone too far?
As outlined above, passive funds have their advantages. It must be said though, as a result of the high demand because of these advantages, coupled with the huge quantitative easing package the Western Governments have delivered over the previous decade facilitating cheap finance, shares in prominent indices like the FTSE100 and S&P 500 are, in my opinion, highly overpriced. Herd behaviour in passive index funds has arguably distorted prices away from their fundamental intrinsic value - the present value of all future cash flows. If you believe my argument, the market is not currently efficient because there is a bubble in the shares within many of these indices - and bubbles cannot exist in a semi-strong form market. However, as Blackrock's paper "Index Investing Supports Vibrant Capital Market" suggests, the scale of index tracking funds are marginal - 7% of assets. While that may be the case now, they are heavily concentrated in the FTSE100 and S&P500 indices. Should inflows into these index funds continue at significant pace, even if you do not believe there is currently a bubble, it would be hard to argue against it in a few years time - providing the market doesn't correct in the mean time.
As we know, in index tracking funds, shares are held based upon their market-cap weighting in a particular index. Potentially, if these funds start dumping shares en-mass perhaps as a result of a change in index weighting or irrational behaviour such as a Minsky moment, their price will decline significantly, again not reflecting their true value. So, although value investing strategies have largely failed in recent years, the bubble may lead to a sort of market alteration which could provide active asset managers with an opportunity to benefit from inefficiency and potentially beat the market through their typical value investing strategy.
Summary
Although I still believe the majority of shares in the majority of markets at the majority of the time are efficiently priced, I understand that it is not infrequent that inefficiencies occur. The fundamental assumption of the EMH, that investors are rational actors, is questionable and this explains the creation of asset bubbles. While it feels strange to be questioning the EMH because of its dogma-like status, I have no doubt the EMH will remain integral to finance for decades to come, and so too will the argument of passive vs active asset management remain a part of investing. Essentially, it is down to the investor and when they see higher returns elsewhere, their current investing method will be questioned regardless.
Comments
Post a Comment