Efficient market conundrum
As far back as I remember I loved picking stocks and doing "Hedge fund work". The more I studied though the more i began to believe that markets are efficient to the point where and I now feel stupid even looking for a job in the hedge fund industry. It doesn't help that hedge funds have been lagging the market for years now...The problem is I'm not sure if there's anything else I really wanna do! Has anyone else had this internal "moral" dilemma? If not, are there any positions that have similar enjoyments without feeling like I'm cheating people out of their returns and money they pay in fees?
Hedge funds are supposed to lag the market in up years.
I had the same academic training and my take is that the efficient market hypothesis does not take into account hard work, ie how much effort a stock picker puts into discovering the information that is out there.
What form of efficiency do you believe in? Why do you believe in it, given the amount of evidence to the contrary? Finally, why do you think efficiency translates into inability to produce excess returns?
Most efficient market theories I've heard of always start under the assumption that the entire market immediately reacts and fairly prices to new information. Except this doesn't account for the fact that many investors don't follow news that closely and are just buy and hold type of investors. Not to mention that they don't deal with the idea that the people who do get the info still want the lowest price possible still making info arbitrage possible.
MartinGhoul: regarding the for of efficiency, I believe in the semi-strong form, because that is what there is evidence for. where might i find evidence on the contrary? source? and finally, efficient markets means that over time on average one will not find pricing mistakes that might lead to excess returns on a risk adjusted basis.
Stroh:
enough investors, including day traders, HF traders, and many hedge funds do trade on news. the market makers have whom to make a market for. and the price fluctuates accordingly. i will agree that it does seem as though these are uneducated traders because many times its impossible to know the full extent of the news that quickly. im not sure what you mean with your arbitrage argument, everyone wants the lowest price, thats why the market reacts so quickly. thaerby preventing an arbitrage oppertunity.
Behavioural finance is a field whose purpose in life is, effectively, to offer counterexamples to EMH. You can read some of the classic papers, such as "Boys Will Be Boys" by Odean or "Massively Confused Investors Making Conspicuously Ignorant Choices (MCI-MCIC)" by Rashes. These are just examples, but there's a lot of stuff out there.
As other people have mentioned, EMH in any of its forms is a concept predicated on a stylised, necessarily simplistic model of the market. As all models, it's extremely valuable, as it provides a crucial framework. Iterative revisions and enhancements of this basic framework allow us to progress towards a better understanding of how things work in the real world. However, let's not for a moment forget that we're dealing with a model, which makes unrealistic assumptions by construction. For instance, EMH necessarily assumes perfect liquidity. There are others.
How long have you been a proponent of the EMH? It's an academic concept; useful for theoretical finance but not realistic. I would venture that most people begin by believing in it, but that starts to wane once you are exposed to the real world and the people who compose it.
if markets were 100% efficient there would be no active managers who beat the indices, period. I did a thread on this a while back, but basically EMH is faulty because it assumes all investors are rational. as someone who deals with investors on a daily basis, this is 100% NOT true.
ya got me DF, lazy response on my part. what I'm alluding to is what Buffett wrote about in the superinvestors piece. i know the math about any year half will outperform half will underperform gross of fees, I just think this topic has been absolutely debated to death, and arguing one way or the other seems almost like a political argument, you will never convince efficient marketeers to believe they're wrong, just like you'll never convince me markets are efficient.
sidebar: efficient is a bad word. markets are efficient in that they react quickly to information, but they are still irrational because humans are participants, which gives investors opportunity to make money. semantics I know, just sayin
Yeah tell me how all investors are rational, I've been long SunEdisson from $7 till the end.
I had a very similar feeling after going through the little coursework my B.Sc degree offered on Asset Management and investments. That stuff almost killed my motivation of pursuing a career in asset management, despite the fact that it is one of the few industries that actually deal with the kind of concepts I have always been drawn to. What I, and many of my peers etc., often fail to see is that EMH nowadays is hardly anything but a convenient theoretical framework. Remember, that the goal is science is not to prove your hypothesis is correct, it is to try to break it because it is basically impossible to prove that some hypothesis is definitively correct (especially in social sciences, but also in physics etc. where certain constants change every time you find a more accurate way to measure it etc.). Hence it is a very convenient framework to use when testing whether certain fund managers are capable of producing superior risk adjusted returns as a result of superior information etc.
When it comes to whether you are producing returns that justify what your clients are paying you, now that is a question that is a lot more up for the debate. Personally I don't really care, as there are many jobs out there where you are selling completely useless shit to people who don't need your product. In the hedge fund business you are at least trying to offer something that should add value to your clients portfolio - all you can do is to do your best to keep the promises you have made to your clients and it is their job to judge whether you have lived up to their expectations or not. In the end of the day, I believe there is a significantly smaller moral dilemma in offering a unique product to your clients for a 2/20 fee structure than offering a closet index fund with e.g. 150bps of AUM every year where you very well know that your client is getting a shitty deal because he could get the same exposure with a fraction of the fees by investing in an ETF tracking the same index.
So personally, I deal with that dilemma by putting in the work and making sure that my investment thesis is something that I believe in. A whole another moral dilemma, in my opinion, is how much value you provide to the rest of the society. Even though I hardly believe markets are 100% efficient, they are still pretty efficient, and in the end of the day this is the only way you actually add value by allocating capital - to make sure that the information reflected in the prices is up to date so that all of the society's scarce resources will be directed towards the most efficient use there is. I'm just doing this stuff because it is something that I enjoy, but this is the dilemma that might eventually cause me to consider doing something different when I feel satisfied with what I've achieved doing this.
If the EMH were correct, there would be no cases of people systematically outperforming the market. Has anyone systematically outperformed the market? Yes. A lot of people.
What does that day about the EMH?
read: manias, panics, and crashes. you'll come to realize that people are not always rational thinkers and thus the market will overshoot / undershoot.
I think for the most part, large-caps are very efficient. However, I think there's always going to be inefficiencies in the small-cap space. Something owned by ~90% retail investors can't possibly be pricing in all available information properly.
The efficient markets hypothesis takes into account a number of assumptions that are often not 100% true in the real world. If you can figure out a way of taking advantage of one of these systematically, you have a shot at selling a strategy to investors.
This talk of "hard work" yielding an advantage when analyzing the shit out of companies, however, sounds like bullshit to me. Everyone works hard in this industry; if they don't, they won't be around much longer. No matter how hard you work, some algorithm on a supercomputer in Renaissance Technologies is going to do 1 year of your work in a matter of milliseconds.
Markets are not efficient. Fear drives irrationality. Moreover, while most investors are "smart," the crowd can misinterpret new information. There's an example that pops in my head from last earnings season - company X reports issues in certain markets. Company Y and company Z traded down ~10/15% for about two months. The issue was specific to company X, not its peers. However, folks thought it might be an industry phenomenon.
I get your point, however you're arguing the wrong things. My biggest concern is the secular trend that's occurring with active money moving to passive. Theoretically with less active players more people should be able to capitalize on alpha generation. In short, I waver with the viability of the industry and which "path" is the most entrpreneurial.
One thing I forgot to mention...
Quite clearly, there is a group of mkt participants who produce returns in the mkt, no matter what. Often, these returns are superior, in risk-adjusted terms. So, really, the fact that these people exist immediately serves as a counterexample to EMH. I'll leave you to guess who they are.
I agree with this point but I think it is often misapplied. For example, a firm like Renaissance Technologies makes so many trades that it's virtually impossible that their returns are due to luck. But for the typical fundamental L/S firm, it is not clear at all. This is why Buffet in "The Superinvestors of Graham and Doddsville" appealed to a non-statistical argument.
Even if markets were perfectly efficient, there would be participants that would have superior risk-adjusted terms simply due to variance. So it's necessary to compare performance against a distribution of risk-adjusted returns that would be expected even if no firms had alpha.
For example (Fama French):
"Only the top 3% of active funds perform about as well as (but no better than) we expect if their true alphas are zero. The measured alphas of these funds for their entire histories are outrageously positive. These are the funds that get top ratings and are deluged with inflows. But their historical performance is only about as good as expected for the top 3% of funds when all performance is just luck and true alpha is zero." (you can argue about the validity of how alpha is measured here, but the idea is that the entire distribution matters)
I wasn't actually referring to HFTs, believe it or not... Furthermore, the mkt participants I was referring to are able to produce superior risk adjusted returns, regardless of the baseline.
Just lie to yourself like everyone else.
It's hard to add value to a discussion after 20 comments have already been made but I'll give this a whirl anyways.
OP, you mention that the more you studied the more you believed that the markets are efficient. (To be clear, I assume you are speaking specifically about the public equity markets. There are a number of other markets that often get left out in these discussions.) I would ask what you were studying. If you were studying academic textbooks then yes you would start to believe that markets are fully efficient. Finance academics are subject to the same behavioral biases as professional active investors. People will do what they are compensated to do. From the perspective of a finance academic, all of finance theory these days is based on modern portfolio theory which assumes market efficiency. That is what they are paid to teach. If it didn't exist they wouldn't have anything to teach, unless they started to teach about the possibility of inefficient markets. That would go against what they have been teaching for the last three decades and the change would be naturally hypocritical. That being said, you could argue that professional active investors will also manage assets actively because that's what they are paid to do. Subsequently, they too will start to believe that what they practice is correct whether or not it truly is. My point is that the perspective that you study from will be biased by those that have written it and will likely not provide you with a fully accurate depiction of reality.
To specifically discuss market efficiency, there are of course the three primary forms (weak, semi-strong, and strong). They progressively build on each other ruling out one additional way to earn alpha at a time. They are predicated on the "rational economic men" assumption. That assumption states that individuals have access to all available information and have no limit to absorb and process information correctly. It states that individuals will maximize their present value weighted average utility. It also states that all individuals are risk averse. If those criteria hold, then the market is efficient.
If you read those assumptions and can genuinely say that you believe the markets to be fully efficient (strong form) then we will never be able to agree. As others have mentioned, there are a number of behavioral biases that make these assumptions irrational. I think another constraint that makes these assumptions irrational that has become more prevalent over the past couple decades are greater institutional constraints. For example, the belief that you must be diversified and that that means you should hold a number of mutual funds and/or ETFs with equity and fixed income assets. Each of those active equity funds will probably hold 100-250 stocks. For an actively managed approach, coming up with that many good ideas is rather difficult but their constraints require them to be diversified. (There are other constraints of course, such as the prevalent asset-gathering mentality.)
That leads me to a couple final thoughts. First, yes it has become harder to generate alpha over the past several decades, but it is still possible. That being said, investing is not supposed to be easy and anyone who thinks it is is an idiot, to quote Charlie Munger. Second, some of the greatest investors that have long-term track records of substantial alpha generation share some common characteristics. One of those is their lack of diversification, or perhaps I should say over-diversification, which I believe is prevalent now. Instead, they often focus on concentrating their assets in their few best ideas. That is radically different from the majority of the industry. Examples: Buffett and Munger, Druckenmiller, Soros, Rogers, Greenblatt, Klarman, etc. You don't have to be concentrated to do well but it is something that many great investors share, among a number of other qualities that I won't get into here.
Investing is hard. It is hard to do better than the market after fees over the long-term, but it is possible. By definition, a small number of people would be able to do it since the market return should roughly reflect the average experience of everyone involved (not totally correct, but that's a topic for another day). As long as humans are involved in investing and the markets, I think there will be some investors that can do better than the market.
I heard an interesting talk on the effect of Cap-weighted indexes being used as the benchmark , causing massive market inefficiencies.
I don't understand why emh and the ability to generate alpha above market have to be mutually exclusive. There are going to be outliers either way. I'm sure there is the yin to Jim Simons yang out there, some sap who just constantly loses money v the market. Russ Hanneman.
You can't prove inefficient markets by sourcing successful funds; as the number of hedge funds in existence approaches large numbers, there'll be more likelihood of a select few finding themselves on the tail of the distribution. If returns were truly random, there would still be a handful of incredibly successful funds that find themselves a few standard deviations above the mean. Not to mention survivorship bias....
I wasn't trying to do this by mentioning rentech earlier. I was just saying that the argument that "spending enough time analyzing a stock allows you to beat the market" doesn't make any sense because there are trading algorithms that "correct" the market within milliseconds the moment new information about a stock exists.
If only looking at a single year, then yes, there will be anomalies that beat the market due to sheer luck. But the statistical likelihood of the same people beating the market year over year simply due to luck/random distribution is essentially zero.
No, even over the course of decades there would be anomalies simply due to variance, especially coming from more concentrated funds.
As a simple example, suppose we have 1,000,000 participants in a coin flipping contest. They flip until they get a tails and count how many heads they got. Just from pure chance you would have a few people get 17 heads in a row, even though those individuals they might deny that it's luck (since from their perspective, the probability of them getting 17 heads in a row was only .0007%
However, if we had an individual that got 100 heads in a row, this would be virtually impossible under the hypothesis of pure luck.
For the last time, the EMH argument is NOT that all actors are rational. That would be like saying that the concepts of supply and demand are silly because market participants are not 100% rational. Sidenote: if you find yourself arguing something that would be obviously true to a child (i.e. all investors are totally rational), there is a VERY VERY good chance you're making a strawman argument. This entire forum could use some help with this point.
Similarly, arguing that transaction costs invalidates EMH would be like saying that taxes or transportation costs invalidates supply and demand. It's a simplification to make the math easier and you're missing the point.
Esuric may have been a little hyperbolic, but wanted to reinforce these issues on his behalf. Respect the two tagged participants contributions as a general rule, so wanted to make it clear that I'm not attacking either of you.
Esuric thebrofessor
Invalidating the rationality assumptions is in effective invalidating the conclusions of the model in its entirety. Far from trivial.
E.g. If we wipe the rationality assumption, EMH assertions regarding bubbles are invalidated.
I suppose the argument is extended to “are actors rational on average”, so perhaps this is your core point. Notwithstanding, I would also disagree with that assertion
Furthermore, as for point 1 regarding information efficiency, I am also skeptical on that point. EMH effectively implies that the effect of given information on a share price is proportionate to its effect on fundamental value. The issue is, the significance of information is not necessarily linear with its availability. To short form my thought process on this point:
• Information availability is not linear to information significance, nor is information availability constant for all levels of information significance, even for “publicly available” information. • Market participants (algo’s included) collectively suffer the cognitive limitations of the human brain and physical labour limitation, specifically relating to finite information processing, limitations of labour as a factor of information production, and limitation on the cognitive ability to process and articulate data to create information (for algos, this would be the primary shortcoming, imo) • As market participants are individually unable to process information efficiently, by summation of that fact, the market as a whole is also implied to be inefficient.
I admittedly have no academic exposure to the topic, but as an outsider, there seems to be some obvious shortcomings to the theorem. If there is relevant literature voiding my points, I would be interested in learning more, but again, I feel EMH is both unintuitive and formally invalid.
(really had chop this post together, so may build on it when I have more time)
Let's try this a different way (by the way, you make good arguments, so I'm not intentionally being dismissive):
Do you think rationality is a built in concept to the theory of supply and demand (i.e. changes in supply and demand will result in consumers / producers changing their consumption etc.)? If your answer is yes (I think that's the answer), I'm curious as to why you think that the issues you list above (limited access to information, cognitive biases, limited processing capabilities etc.) don't lead you to believe that supply and demand (or any other economics theory) is invalid.
More simply put - the concept that markets in their totality incorporate all available information and respond rationally is a core concept of economics. If you reject that, you effectively reject everything we base finance on. For the record, this does not require believing the everyone is always right, or even that every individual is rational.
so.... whats the conclusion?:)
I am only going by experience and am not an academic, but I believe that the market is highly inefficient and that this can and does produce excess return for traders that do things the right way. However the source of inefficiency is more on the risk management side then the idea side IMHO.
The average market participant has no clue about how to size trades and manage risk and thus many will fail and give money to better managers even if they are doing rigorous research and coming up with good ideas. Either they are over-betting their books and therefore get taken out on random fluctuations or their capital is flighty and pulls at bad times because they got to the idea too early. Every big trade that makes headlines leaves in its wake a group of traders who had the right idea but were stopped out before the event happened due to poor risk management. This group is much larger, although less discussed, then the people who made the money on the trade. Brazilian rates over the last year is a great example...lower rates was the "right idea" but many people went out of business (including big names) by being early and over-betting their capital at the wrong time. I believe this inefficient risk management is just as big a source of alpha in markets as "hard work", "smarts", or whatever we call the ability to find good trades.
I suggest young traders put as much work into really understanding the math behind proper position sizing as they do on the "sexier" topic of idea generation.
This perspective is actually quite similar to the academic idea of balancing risk factors, taking on exposures that will produce returns but at the cost of taking on non-diversifiable risk. However, the approach you describe is more subtle since it's not as crude or systematic as "buy low P/E stocks and short high P/E stocks."
not just young traders, but ackman, ruane cuniff, and pabrai as well...
And Paulson...
Speaking of which, don't the stories of various Chinese reverse merger frauds actually cast into doubt even the EMH assertions about mkts reflecting all publicly available information and reacting to new such information rapidly?
Thanks for sharing your perspective. Would books or other sources of information would you recommend to someone interested in learning about risk management in regards to trading?
jenson123 : I'm not qualified to chime in on behalf of Bondarb, but I had a (very) short stint in risk mgmt at a macro fund. A book that I highly recommend is Trading Risk by Kenneth Grant.
https://www.Amazon.com/Trading-Risk-Enhanced-Profitability-through/dp/0471650919
He was prev the former chief risk officer at Tudor, SAC, Cheyne and Exis - basically, the guy has been around... The book goes over all the basic risk math you'll need, yet where it shines is its extensive coverage of the practical aspects of building and adhering to a risk management framework that fits your trading style. That's key because risk management is more about the consistent discipline and less about using the latest quant gimmick to estimate your risk.
One of the few books worth keeping on your desk.
Well said, Bondarb! This happens to be my second favourite post on WSO (first is from the wso macro league).
I know this is a completely separate topic, but without going into anything proprietary, mind providing some insight into how you go about sizing your positions?
Thanks for the awesome posts.
Edit: I'm printing this out and laminating it.
Can't you argue that this inefficient risk management process and lack of understanding in position sizing is also a function of understanding correlations and the drivers of macro markets?
The U.S market is pretty efficient, especially the stock market. However, when you get to know other markets (emergent or even other developed countries) you can see that there are still a lot of money to be made.
Beating the Efficient Market - See the Future (Originally Posted: 10/05/2010)
When I interned a few years back, the bank I worked at ran a great training program where traders came in each morning to discuss the product on their desk. The office, sitting on a second floor balcony at the 50 yard line of the trading floor, was a great way to start the day. Traders from every asset class and role would describe what drove their decisions.
One trader who stood out worked covering tech companies on a prop desk where he speculated aggressively on video game releases (yes video games). The 35 year old was sharp and surprisingly encouraging. You come across these types occasionally in the bank. People who are willing to help others. Can you fucking believe that?
Anyways, back on topic, this trader described the need to find the ripple effect trade. Use the sequence of cash flows to predict the future before the market does.
Michael Lewis spoke of a similar trade when someone on his desk traded potatoes during a nuclear meltdown.
In the morning we would always discuss breaking news and the trader would immediately ask, "What's the trade!?!" Maybe Pfizer announced a drug recall. The point was the trade was not Pfizer. That was the trade a week ago. The trade was somewhere in the supply chain.
Well when I read the Volkswagon article today from WSJ (below), I couldn't help but think, "What's the trade!?!" Volkswagon is pumping up the US market big time with a new $1Bn domestic plant and targets at growing volume 3x! (I was surprised to read that they only control 3% of the market).. VW is not the trade, but who is? Do you short Kia or Toyota? Even if they stay on top, they'll have to spend money to compete. I assume growing a market that aggressively involves big time Ad spending. Does VW outsource advertisements to an agency? What is the obscure trade?
http://online.wsj.com/article/SB100014240527487037435045754935042671147…
Wouldn't the ripple effect trade for something like this be the corp that would be building, setting up, etc. all of the infrastructure for the 1bn dollar factory?
OP, I completely agree. That's a great way to play equity markets and related securities. I don't know enough about other product classes to comment.
One thing though, don't knock video game speculation. It's how I make my damn living :).
happypantsmcgee:
i think most investors would build the expected sales from the new plant into their models rather than waiting until the factory was actually completed.
If you don't mind, i'd like to know which bank you interned at. That definitely sounds like a great program.
I've met that type of guys only once or twice during my internship, but that was definitely encouraging for kids like me who's still in school.
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