The efficient market hypothesis – real or outdated

People continue to question the health of global capitalism. But the damage caused by non-functional stock markets is not receiving enough attention. Fifty years after the publication of a remarkable document presenting the hypothesis of effective markets – that investors respond rationally to publicly available information – it is time to think again.

Active investing involves two main strategies. One is based on the cash flow expectations that each asset can generate. The other responds to short-term price movements and ignores fundamental value.

Investing cash flows and investing only in prices are realized in different ways and together represent the sum of the actions of investors in determining the prices of assets.

The efficient markets hypothesis only takes into account the first strategy, which assumes that prices reflect the consensus expectations of cash flow investors. Although modified and qualified over the years, the basic proposal remains unchanged.

But think of the evidence of trends and inertia, and of bubbles and crashes. Market participants monitor the impact of short-term flows and are ambivalent – at best – about the idea that markets are effective. They know that much of the stock market deals have nothing to do with fundamental value and that few professional portfolios are actually invested solely for long-term cash flows.

Despite these reservations and the lack of alternatives, the efficient markets hypothesis continues to underpin some of the most important investor decisions, from the largest institutional funds to the smallest private saver.

One major example of the problem is the use of capitalization-weighted indices as benchmarks for the composition of passive funds and for the effectiveness of active funds. Comparing portfolio returns with index returns is considered a good practice, however short the period of review. But treating indexes as a neutral default choice only makes sense if pricing is effective.

For their part, politicians accept that stock markets reflect the wisdom of the crowd, limiting their role in post-market collapse. They use market marking rules when regulating financial institutions and approve products that improve liquidity or broaden their choice. This is reasonable in an effective world, but not otherwise.

There is a need for a better understanding of why investors use these strategies and how this use distorts prices. Research focuses on issues that arise when asset owners and fund trustees delegate the responsibility to outside managers. The main concern here is that trusts are unsure of the capabilities of their asset managers.

Accordingly, most trustees impose limits on how far the yield can be diverted from the return on the benchmark. Even when unrestricted, managers are eager to prevent the results from slipping far below the return on the index so that their competence is not called into question.

Benchmarking pressures come to the fore when prices in a given sector or asset class are moving well ahead. Managers who previously considered one sector as unattractive and did not participate in the upswing are bound to pay higher price buyers. This enhances the initial rise to the point where assets become high risk and overvalued.

It is no surprise that a theory predicting performance cannot explain inefficiency, nor show investors how to act properly in the face of inefficiency.

Below-index weights in equities or rising sectors have a greater and potentially unlimited impact on returns than overweight positions in those with declining prices. So the pressure to act is always stronger as markets rise.

One pricing strategy gives rise to another, exacerbating the situation. Benchmarks should work when prices cross the threshold – but inertial investors buy as soon as the trend becomes apparent. The latter effectively use indexes that have no alternative but to pay higher prices.

The result is a generalized bias for overestimation. This analysis is consistent with longstanding evidence that high-risk stocks have historically yielded lower returns than their low-risk counterparts.

Price strategies, ignored by the effective market hypothesis, create systemic and chronic distortions that are too large to counteract cash flow investors.

It is no surprise that a theory predicting performance cannot explain inefficiency, nor show investors how to act properly in the face of inefficiency.

These include changing the terms of the trustee’s delegation to an asset manager so that the latter focuses solely on long-term cash flows, combined with improved monitoring by the trustee to ensure compliance. More efficient markets would bring private profits for everyone except inertia players.

But the biggest reward would be the social benefits of a more efficient allocation of capital. This could breathe new life into capitalism.

Source: Financial Times

 Trader Aleksandar Kumanov

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