The odds of beating the market are 50/50, or so we thought.
Tommi Johnsen, PhD | Advisory Board Trent Ambler, MSF | Portfolio Manager
Key Point: Markets have potentially become less efficient over time
Implication: The methods for picking winning investments have changed dramatically over the last decades. For sufficiently equipped investors there are more opportunities to achieve meaningful results.
____________
In a recent interview, Cliff Asness of AQR was quoted as saying that the market has gotten a bit less efficient throughout his career.
“Over my career, [32 years] I actually think markets have gotten somewhat less efficient meaning prices are a little bit more disconnected from reality. Maybe I’m biased by having a front row seat but I think that after the last 30 or so years I’d say the market is somewhat less efficient than when I started.”[1]
The suggestion that markets have perhaps gotten a bit less efficient is quite notable.
The efficient market hypothesis has been used as a framework for evaluating the likelihood that “picking winners” amongst a set of different investment opportunities is likely to yield sustained outperformance over time. More specifically, in the case of equities, the efficient market hypothesis provides a mechanism for deciding whether an active manager picking stocks and building a portfolio is likely to outperform the broader market over time (with the “broader market” often proxied for by the S&P 500). Two specific determinants are of particular concern to the Efficient Market Hypothesis, those being how much information is available to investors, and importantly how quickly that information is reflected in the market price of a stock. In academic- speak: ‘An efficient market is one where the market price is an unbiased estimate of the true value of the investment’[2]
Market Efficiency Definition[3]
Weak Form Efficiency: All past price information is reflected in today’s stock price if markets are weak form efficient the exclusive use of past pricing patterns will not deliver sustained outperformance. Technical analysis will not work.
Semi-Strong Form Efficiency: All public information including both past price data and all publicly available fundamental data is reflected in today’s stock price Neither technical analysis nor fundamental analysis can be used to consistently pick winners. This level is largely regarded as the limit of market efficiency.
Strong Form Efficiency: All information is reflected in today’s stock price including non-public or insider information. We know from various cases of insider trading that public equity markets are certainly not strong form efficient and thus the debate around market efficiency tends to focus on the Semi-Strong and Weak Form levels.
Misconceptions and Rationales for Active Management
The definition is important, but what is more important to understand is what market efficiency requires and what it does not require. EMH does not require that the market price of any security be equal to true value at every moment. It only requires that pricing errors behave as a random variable. [4] Market efficiency does not suggest that it is impossible to pick winners, instead the theory states that the odds of picking winners and losers are roughly balanced – that is there is roughly only a 50% chance of picking a stock that beats the broader market.
To be more precise, any difference between the observed market price and the unobserved true value, are randomly distributed around a mean of zero. If that is true, no category of investor, using any investment strategy, will be able to consistently or predictably find stocks that are overvalued or undervalued with any regularity. This applies to the short-run, long-run and everything in-between. A simple example: Under the efficient market hypothesis a stock with a low PE ratio is not more or less likely to be mispriced than a stock with a high PE ratio.
Another common argument against efficiency states that while both price level and publicly available fundamental data may be quickly reflected in today’s stock price, there are many examples of pricing errors and therefore markets cannot be efficient. Again, this is a misconception, market efficiency does not suggest that pricing errors do not occur[5] it simply says that pricing errors will be random and offsetting.
It is only if such pricing errors are in fact not random that a market could be said to be something less than Semi-Strong Form efficient. If a pricing error persists because of some idiosyncrasy in the overall market pricing mechanism then it is possible to exploit this idiosyncrasy and outperform.
As such, justifiable explanations for the existence of priced risk factors i.e. Value, Quality, Momentum, Liquidity, and Sentiment are grounded in persistent divergences from a rational pricing mechanism in the overall market. If something like buying cheap stocks works consistently then this is due to a pricing anomaly in the overall market which is otherwise at least somewhat efficient.
For Asness to suggest that markets have gotten a bit less efficient over time means that there are perhaps more of these anomalies that originally thought, and that for investors who are willing to deploy the necessary resources and time into discovering and exploiting these there will be substantial opportunities for outperformance!
[1] Asness, Cliff. Interview by Sonaili Basak. Bloomberg, 25th of June, 2024, https://www.bloomberg.com/news/videos/2024-06-25/are-the-markets-broken-aqr-s-cliff-asness-weighs-in-video .
[2] Damodaran, Aswath. Investment Valuation Third Edition, Wiley, 2012. P. 112
[3] Bodie, Zvi, Kane, Alex, and Marcus, Alan J. Investments Tenth Edition, McGraw Hill, 2014. Pp 349 - 380
[4] Damodaran, Aswath. Investment Valuation Third Edition, Wiley, 2012. P. 112
[5] Bodie, Zvi, Kane, Alex, and Marcus, Alan J. Investments Tenth Edition, McGraw Hill, 2014. Pp 349 - 380