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About that Nobel-influenced investment advice

The award of the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel to Eugene Fama (along with Robert Shiller and Lars Peter Hansen) has prompted a number of economists and finance professionals to note that Fama's work on the efficient market hypothesis underlies the buy-and-hold-the-market strategies embodied in a number of mutual funds, of which the Vanguard Index 500 has long been the flagship. We have been treated to another round of stories about how hard it is to beat the market. Fine. Let's remember the principle of the margin, though. The efficient market hypothesis assumes that there exists a fairly numerous group of people trying to spot potential arbitrage opportunities and to take advantage of them. Index funds and active investors act as checks on each other. If everybody is a passive index investor, there are opportunities for analysts to generate insights that nobody else is generating and to use them as the basis for profitable trades. If everybody is an active trader, given how many people do not have new insights to generate, some (most?) are better off giving up the small chance of sustained above-average returns for the certainty of lower fees. The underlying point to remember is that market efficiency is not something that happens automatically. It is the result of ceaseless activity by many people. Some of them are bright enough to beat the market, not by holding every stock on the market but by specializing in certain segments. The Forbes 400 list has quite a few hedge fund operators on it. As I interpret the implications of the efficient markets hypothesis for investing, it is that some people can beat the market consistently because they really do have superior insight. Warren Buffett was not just lucky; he reads financial statements with the enthusiasm that other people reserve for pulp novels. Most of us are better off riding on the efforts of others, though, just as we are better off not doing our own plumbing or our own songwriting. And if you are reading this now rather than plowing through corporate financial statements, you are very likely part of that great majority.

ADDENDUM: As John Bogle of Vanguard has remarked, he was unaware of Fama's work when he developed index funds at Vanguard. Bogle's motivations were the high fees and lack of diversification he saw in existing financial products; he thought he could do better, and he did. I was aware of this, hence I did not say that Fama influenced Vanguard. It's an interesting case of how an insightful businessman and an insightful academic reached the same result by different routes.

  • dcarroll001

    This is probably the best commentary on the EMH that I've seen. As I see it there are three problems with the EMH as usually presented: 1. If markets are efficient, then the market for mutual funds should also be efficient (certainly most academics make an exception here). The fee is the price for active money management, and if the fee is too high (or passive fees too low), then capital would flow until the fees converge. One could make the case that rigid institutions or investor psychology are to blame, but those problems are not unique to the fund industry, and are arguments against EMH. Therefore, assuming EMH is true for funds, investors are getting something of value in exchange for the higher fees not captured by performance numbers. 2. The EMH assumes the existence of active investors paid to take advantage of market inefficiencies. However, if all or enough investors move to passive vehicles, active investors disappear and the EMH breaks down (indeed, the financial markets cease to function). Therefore, if EMH is true, there must be active investors making profits and charging fees. 3. Passive investors are free riders. Active investors don't work for free, and are paid by their clients. However, markets are structured for transparent pricing, meaning that in order to trade, investors must reveal their proprietary opinions about the efficient price. Passive investors use that information in aggregate and trade off of it. So they are benefiting from the fees paid for by others. Therefore, based on 2 and 3, passive investors are probably raising the overall costs in aggregate, some directly but mostly indirectly, even if they themselves enjoy lower fees.

    Of course, empirical evidence of the average fund manager underperforming the indexes after fees is the most often cited support for EMH. However, as I am sure you are aware, that is circular, because the "average fund manager" is just another index, and a proxy for the market much like the S&P 500. Thus, the empirical evidence just shows that the average investor doesn't outperform the average investor, and when fees are deducted, they underperform.

  • Lio

    “Warren Buffett was not just lucky”.

    Where is the evidence? Empirical studies that prove that Berkshire Hathaway made excess risk-adjusted profits?

    Even if it were proved that WB outperformed the market in the long run, EMH would still be 99.999…% true!

    Here's John Cochrane on EMH and Fama's work in general (a must read):

    • Kurt Schuler

      Here is the evidence: We know what lottery winners look like. They include a lot more women, young people, and people who can't speak even their native language well than the Forbes 400 includes among its self-made financiers. I read Cochrane's piece a couple of days ago. It's good, and there is nothing in it that contradicts my post.

      • Many factors influence inclusion in the Forbes 400, other than information not present in capital before a Forbes 400 member purchases it. Being in a position to trade capital professionally requires leaping many hurdles. These other factors could account for the small number of female, young and illiterate people in the group. Obviously, when women were customarily, even statutorily, excluded from most professions, their absence from the Forbes 400 was not evidence that members knew anything that women didn't know. The wives of Forbes 400 members presumably know things that other women don't know, but the wives are not members of the Forbes 400 themselves.

        More to the point, market efficiency requires competition to bid away inefficiency. The efficient market is an equilibrium condition, not an inviolable law of nature. The efficient market theory assumes that insiders bid away inefficiency, so "can't beat the market" necessarily applies only to outsiders. Outsiders are simply people who learn information relevant to price later in the game than insiders, and these days, "later" can be measured in milliseconds.

        The EMH does not imply that professional arbitrageurs can't make money. It does imply that an arbitrageur consistently outperforming the market has "non-public" information, but it does not imply that a member of the Forbes 400 outperforms the market for this reason. Drawing this conclusion from the demographic profile of Forbes 400 members conflates all sorts of things.

        • Kurt Schuler

          You made some good points. Mine was that if fortune in finance is really just the result of a few people winning the lottery (or, to use a more precise analogy, flipping a coin and having it come up "heads" 20 times in a row), there should be more variety in the winners than we see. Why don't we say anybody whose illiterate, for instance? True, a highly literate person has a much better chance of getting start-up capital than an illiterate one, but that's the equivalent of starting a couple of coin flips ahead, not 15 or 16 coin flips.