Confusion over market efficiency

In: Uncategorized

13 Aug 2012

This is my latest Perspective column for Fund Strategy. It is more technical than normal.

Last week’s column on short-termism omitted a key element of the debate: the discussion on whether markets are “efficient”. This notion has important consequences both for fund management and for the debate about what caused the crisis. When Vince Cable announced the Kay review of equity markets he used the opportunity to blame the financial crisis on a belief in efficient markets.

The Business Secretary argued that until 2008 “the theory of efficient markets ruled the roost”. Afterwards there was “disquieting evidence that markets were neither efficient nor rational”. He went on to argue “the wreckage of the banking sector is exhibit number one”.

In response to the minister’s call the Kay Review included an accurate but low-key chapter on market efficiency. It concluded that financial regulation needed to be better designed. The report ducked the question of whether the theory itself was one of the main culprits in causing the crisis.

To draw conclusions on this thorny question it is necessary to go back to first principles. In particular to examine what exactly the efficient markets hypothesis claims, what its implications are for fund management and its economic consequences.

In its simplest form the EMH contends that the prices of financial assets in efficient markets reflect all the available information. From this perspective the financial markets are information processing machines that continuously price and reprice assets.

It does not necessarily apply to all markets. For instance, if insider trading is rife or if the market is not liquid it will not be counted as efficient. But stockmarkets in developed countries, and an increasing number in the emerging world, are generally viewed as efficient.

Eugene Fama, the University of Chicago academic who first formulated the EMH in the 1960s, distinguished between three variants of the theory: weak (which just takes into account historical asset prices), semi-strong (which includes all publicly available information) and strong (where some investors may have monopolistic access to relevant information). But these three forms of the theory are more to do with testing it empirically than with the thrust of the argument.

It should be quickly clear to readers that the EMH has important implications for fund management. Avid supporters of the theory are likely to be highly sceptical of the ability of managers to outperform the market over the long-term. This is not to do with the deficiencies of managers but, on the contrary, because EMH advocates believe markets work so well.

Strong advocates of EMH are therefore likely to favour index funds as core holdings in investment portfolios. From their perspective it is not worth paying a high fee in a forlorn hope that active managers can consistently beat the market. Of course some active managers will perform well by chance but it is not possible to identify them in advance. In this conception the role of active management is best confined to specialist portfolios.

In contrast, EMH sceptics are more likely to favour active management. They may also argue that active managers provide other useful services such as risk management.

Once the discussion enters the economic terrain it becomes murkier. Critics of EMH often conflate it with a dislike of free market economics. But muddling the two together can only be confusing since, although it is possible to be both a free marketeer and an EMH advocate, they are not the same thing. One is an account of how financial markets work while the other is a view on the desirability of a limited economic role for government.

There are many ways in which EMH is claimed to have had a damaging economic effect. Most often the argument relates to lax regulation. It is often contended that regulatory structures are inadequate because those who design them take too benign a view of markets. The EMH advocates are accused of underestimating the dangers of bubbles and subsequent market busts.

Defenders of EMH often respond that the critics caricature their argument. EMH supporters argue, with considerable justification, that they are well aware that bubbles can exist. Their case is that prices reflect all the information available at a given time. That does not preclude new information becoming available in the future.

Instead their claims relate to the possibility of investors exploiting price anomalies in the market. As Burton Malkiel, a Princeton professor and advocate of EMH, has argued: “At its core, EMH implies that arbitrage opportunities for riskless gains do not exist in an efficiently functioning market and if they do appear from time to time that they do not persist.”

There are also more fundamental reasons why criticisms of EMH are often misplaced. First, EMH is better seen as a hypothesis about how markets work rather than a set of principles people act on. It is not akin to, say, Newtonian physics which provides the necessary understanding for engineers to build bridges or construct steam engines. It is really just a claim about the patterns of movement of financial asset prices.

The most important weakness of the EMH critics is their failure to differentiate between the financial markets and the real economy. Indeed both critics and supporters of EMH often share this error in common. Both sides erroneously tend to assume that talking about the stockmarket is more-or-less akin to discussing the economy.

In reality there is no straightforward relationship between equities and the economy. The real economy is mainly driven by such factors as capital spending – real investment in companies – rather than the factors that drive share prices. That is why it is possible to have a strong economy and a weak stockmarket at the same time. The converse is also true.

Those who criticise the EMH on economic grounds are generally just confusing matters. Their real objection is to free market economics and to the high profile of financial institutions in contemporary capitalism. Such critics are entitled to attack both targets but it would be better if they did not conflate them with a technical theory about financial markets.