Bear and Bull

Debunking the Inefficient Market Hypothesis

Bear and Bull

It is not uncommon to find financial pundits, analysts, financial advisors, or investment consultants that are willing to recommend indexing when it comes to a particular segment of the market; mainly, large-cap and even mid-cap companies within the United States. This is common curriculum in the CFA, AIF, CFP, and CIMA designations. Unfortunately, it is also common in this curriculum to mention that other parts of the market are inefficient and therefore active management may be justified, with may being the key word.

There is no rigorous discussion of why this may be a plausible hypothesis, but some general statements about limited market participants, barriers to entry, or just the mere fact that if it is something that we are unfamiliar with, then it must be true. For example, how many of us are familiar with small-cap market within India? Most of us would say “no,” which may then lead us to the conclusion that it therefore must be inefficient because we are unfamiliar. In contrast, most of us can rattle off 20-30 of the largest companies within the United States. The point is that these are general statements and have no peer-reviewed empirical backing.

We recently came across a presentation that another advisory firm gave to a $500M City Retirement Plan that made the following summations:

  • Domestic large-cap and mid-cap equities are highly efficient and make sense to index from a cost and replication perspective, for all client sizes
  • The firm believes that it is prudent to pair index strategies with active managers, even in efficient markets, given their ability to provide greater downside protection in negative market environments
  • Index strategies work best in rising market environments
  • In choppy and declining markets, active management has the greatest opportunity to add value relative to their respective benchmark
  • The longer an index performs well in an asset class that has historically demonstrated high levels of inefficiency, the greater the likelihood for a reversal in favor of active management

We felt compelled to address these issues because they are pervasive across our industry. As I mentioned before, it is part of the core curriculum of many of the highly regarded professional designations that are out there. We are going to address these summations by putting them into two categories: market efficiency in general and active management alpha in down markets.

First, in order to say that a market is inefficient, we must be able to describe what an inefficient market would look like. This is what Nobel Laureate Eugene Fama called the Joint Hypothesis in his famous Efficient Capital Markets: A Review of Theory and Empirical Work (1970).  In order to test whether or not markets are efficient, we must be able to model what markets would look like if they were efficient. With the use of asset pricing models such as the CAPM (Sharpe, 1970) or the Fama-French 3 Factor Model (Fama/French, 1992), we can describe what markets look like when in equilibrium. In simple terms, in efficient markets, participants are compensated with return based on the risk taken. High returns are associated with high degrees of risk and vice versa.

An inefficient market would therefore be a market where investors are earning returns above what would be expected for the risk taken. This would be the elusive alpha that is sought out by active money managers.

The University of Chicago has dedicated vast amounts of financial resources to maintain the Center for Research in Security Prices (CRSP) Survivor-Bias-Free US Mutual Fund Database, which is the single most utilized database in the field of empirical finance. For anyone who has a Ph.D. in the field of financial economics is well aware and has probably used this database when testing different hypotheses about asset pricing. It covers all open-end mutual funds of all investment companies domiciled within the United States. It is extremely important since it provides a real-world sample of professional money managers in which we can answer the question of whether or not markets are efficient. We can look to see if there are actual managers out there that are earning excess risk-adjusted returns.

Dimensional Fund Advisors (DFA) recently updated their US Mutual Fund Landscape with data from the CRSP database as of year-end 2014. They reported that for the 15 years ending 2014, only 19% of equity funds had survived and outperformed their respective benchmark. This is pervasive across all different types of mutual fund styles including large-cap, mid-cap, small-cap, growth, value, blend, and foreign. Likewise, only 8% of fixed income mutual funds have survived and outperformed their respective benchmark over the same time period. DFA highlighted the important role that costs (expense ratio, turnover, etc.) play in the investing process as one of the key reasons for these outcomes. See more information on Stock Picking here



This is not to say that all markets are perfectly efficient. While there may be some substantive truth behind there being inefficiencies in certain corners of the U.S. market and markets abroad, the cost associated with trying to exploit those inefficiencies are too great compared to the excess return that the portfolio managers are trying to capture. 

In answer to the summations above about market inefficiencies, we would say that although it seems plausible for inefficiencies to exist in certain markets, it has been proven to be extremely hard for professional money managers to exploit those inefficiencies beyond a reasonable doubt and therefore anything other than applying an indexing approach to those markets is just wishful thinking.

Now let’s address the issue of active management working in down markets. The pitch usually goes like, “Active managers perform better during down markets because they can do things like raise cash or just stick to high quality stocks versus an index which will ride all the way down to the bottom with the overall market.”

There have been numerous studies done on this particular topic and results have been mixed. In Modern Fool’s Gold: Alpha in Recessions published in the Fall 2012 edition of Journal of Investing, authors Shaun A Pfeiffer and Harold R. Evensky studies concluded that alpha from active managers is isolated to a subset of the manager universe. Further, the authors conclude that this outperformance displays weak persistence and there is no meaningful impact of prior superior performance in recessions on performance in subsequent recessions or expansions. Their research covered the time period from 1990-2010. In their own words they state, “The findings support a low-cost passive investment strategy across all business cycles.”

Now beyond the mixed conclusions that the academic community has come up with in regards to this specific topic, we can also use basic intuition and logic. The vast majority of money in the world is actively managed. If there are active managers who are raising cash in down markets or selling low quality stocks to buy high quality stocks, who is on the other side of that trade? Basic logic would dictate another active manager, on average, is on the other side of that trade. Someone has to be willing to buy the stock a particular active manager is looking to sell in order to raise cash. Likewise, someone has to be willing to sell those quality stocks that a particular active manager is looking to buy. Someone has to win and someone has to lose. This logic makes sense with the author’s conclusions that only a subset of active money managers are able to deliver alpha in down markets, but we cannot identify who they are in advance. When a "false discovery test" was applied to the alpha of managers, the concept of alpha being a myth was solidified. 

Once again, in answer to the summations made about active management adding value in down markets, we would say that there is no consistent empirical proof that active managers can deliver alpha during down markets nor is there enough reliability in their performance that we can pick, with a high degree of certainty, which ones are going to outperform. Doing anything other than indexing during down markets is once again just wishful thinking.

We don’t expect these general summations to go away anytime soon until the curriculum of professional designations is revised. From empirical standpoint, these summations do not have a leg to stand on. For something as important as the retirement of city workers, who are probably not as literate in investing as their consultants are, having an investment strategy based on wishful thinking is not prudent and not expected to be successful. Why don’t we just go to Las Vegas and put the entire $500M on “red” and hope for the best?

PS: This topic was also covered by William Bernstein in his article titled The Big Lie and in a previous IFA article titled When Mythology Is Confused with Reality.