Sunday, March 19, 2006

Asset allocation basics: Part VI Efficient Market Hypothesis

I apologize for the lack of posting this past week. It was a result of my work schedule as well as my trying to write longish articles. This post and the next contain little practical information, but hopefully provides food for thought for those who are interested in the deeper meaning of things.

We have now established the importance of asset allocation, now we direct our attention to funds within each asset class. It should surprise no one that for many asset classes, index funds are the most appropriate choice. Instead of belaboring this point, I will present first the efficient market hypothesis (EMH), an academic theory behind index funds. The discussion then segues into some personal opinions on active and passive investing philosophies. In keeping with the name of this blog, I will maintain a balance between the two.

A true classic that belongs in every investor's library. The overall focus is on warning you away from strategies that don't work. This is one of the first books that set-off the index fund revolution. The author is a professor of economics at Princeton University.

EMH has three versions: the week, semi-strong and strong. From Wikipedia

Weak-form efficiency
  • No excess returns can be earned by using investment strategies based on historical share prices or other financial data.
  • Weak-form efficiency implies that no Technical analysis techniques will be able to consistently produce excess returns.
  • In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security. Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements.
Semi-strong form efficiency
  • Share prices adjust instantaneously and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information.
  • Semi-strong-form efficiency implies that Fundamental analysis techniques will not be able to reliably produce excess returns.
  • To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous. To test for this, consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner.
Strong-form efficiency
  • Share prices reflect all information and no one can earn excess returns.
  • To test for strong form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. When the topic of insider trading is introduced, where an investor trades on information that is not yet publicly available, the idea of a strong-form efficient market seems impossible. Studies on the US stock market have shown that people do trade on inside information. It was also found though that others monitored the activity of those with inside information and in turn followed, having the effect of reducing any profits that could be made.
  • Even though many fund managers have consistently beaten the market, this does not necessarily invalidate strong-form efficiency. We need to find out how many managers in fact do beat the market, how many match it, and how many underperform it. The results imply that performance relative to the market is more or less normally distributed, so that a certain percentage of managers can be expected to beat the market. Given that there are tens of thousand of fund managers worldwide, then having a few dozen star performers is perfectly consistent with statistical expectations.

I’m not a big fan of the strong form EMH. Those with penetrating insights of larger macro trends can and did profit handsomely by riding those trends. Commodities in the 70’s, Japanese stocks in the 80’s, and tech stocks in the 90’s are the best examples. These macro trends are of long enough duration compared with an individual’s investing life span as to make the question about long term consistency moot. They are also of large enough magnitude to generate a life-changing amount of wealth for the astute investor. I will say unabashedly that this is the main aim for the actively managed portion of my portfolio. For EMH to apply to these secular trends, enough people would have to be prescient enough to ride them – call me a cynic, this is simply contrary to the observed human nature!

I also find it implausible to ascribe great performance solely to luck. The probability of a random money manager placing in the top 1/3 for 15 years in a row is 1 out of 3^15 or more than 14 million. I have in mind here Bill Miller of Legg Mason who has beaten the S&P 15 years straight, also assuming here only 1/3 of the domestic large cap funds beat the S&P in a given year. Since 14 million is a lot more than the number of money managers out there, Miller’s performance is not likely to be solely due to chance.

Of course, the semi-strong form of EMH alone is sufficient to justify using index funds. There is quite a bit of controversy in both academic and practical circle: at stake are billions of management fees. If actual performances are the final arbiter, in the category of large cap US stock mutual funds at least, the numbers have spoken in favor of the index funds. But this is far from the final word. In the next post I want to look at active and passive investing philosophies, some common misconceptions and point out some concerns of mine regarding the popularity of passive investing.

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