Markets are efficient but the focus is wrong

The April 11 issue ofMoney Managementfeatured Robert Keavney’s Messenger article. While I respect Robert, I am afraid that his article could produce many misunderstandings of Efficient Market Theory (EMT).

There seems to be confusion as to the definition of EMT. This was a term coined by Professor Eugene Fama in his doctoral thesis in 1962. The theory holds that stocks are always correctly priced since everything that is publicly known about the stock is reflected in its market price.

EMT is not about perfect pricing but rather imperfect pricing in a random manner. The point of capitalism is that capital markets work and that risk is rewarded.

Therefore, the market is the sum total of all participants’ estimations and all known information. One manager or one investor cannot consistently out-predict or out-forecast every other participant. There are indeed times when, with the benefit of hindsight, we see that the sum total of investors are behaving in a manner that seems hard to justify.

The example of the Nasdaq trading at the PE of 150 was stupid, just as when it was trading at 100 or 50. Should one have stood aside when the Nasdaq PE rose to more than 30 times earnings in the early 1990s and should one continue to stand aside now because, despite a 70 per cent fall, Nasdaq is still trading at crazy PEs?

In 1992, Professors Fama and French developed a dramatic paper that helped to explain the relative out-performance of some managers by defining the different dimensions of risk. They documented the three factor model, which explained the smaller companies’ effect and the value effect, which is evident in all markets around the world.

Value and size are dimensions of risk and in a logical, efficient market over time those investors willing to take on the increased risk of small companies or distressed, out of favour, companies should be rewarded with a higher rate of return.

It should cost more for a riskier company to raise capital, via a higher interest rate on borrowing or a lower share price on equity capital. Therefore, it is a cost of capital argument, not an inefficiency argument.

Some managers taking greater small company or distressed company risk get a higher return, while others pay the price, ending up with a lower return than the broader market. The returns of all managers or market participants can be charted and you find the normal bell curve distribution, with most managers falling close to the index and a few outliers at the extremities.

We all know who the good outliers are. They get massive inflows after they have achieved the performance and have the cash flows to swamp us with advertising spend about their past performance. The bad outliers disappear or are quietly taken over, so we end up with a survivor bias. The trouble is none of us can predict who the next batch of good outliers are.

For the past five years it was Colonial First State and the five years before that it was Bankers Trust. Who will it be over the next five years? The examples Robert uses to prove his theory that some managers can predict the future happen to be extremely disciplined managers who stick to their strategy and capture the small company and value risk premium. He mentions Warren Buffett, Kerr Nielson and Robert Maple Brown because they are out-performing their peers at the moment. He doesn’t mention they were all under-performing their peers four or five years ago and neglects to tell us who he has chosen to out-perform their peers over the next five years.

In my view, it requires an abandonment of commonsense to believe as Robert purports to, that in spite of overwhelming scientific evidence to the contrary, the markets with millions of participants are not more efficient at allocating resources in a risk adjusted manner than Robert is on his own, or with the help of a team of researchers.

For example, during the tech boom, those investors speculating and driving prices to extremes and expecting extreme returns were rewarded with extreme risk. The trouble was finding the guru who would be able to predict the day or even the year when the time of reckoning would come. Certainly the fund managers involved in that sector did not seem to have this power.

On June 30, 2001, if there was a swing of 70 points in the ASX 200 index in the 15 minutes after the market closed, was Robert or anyone able to predict this ramping and profit from it as the efficient market corrected it within a few minutes of opening the next day?

On October 20, 1987, if our market was 25 per cent lower at the end of the day than the beginning, was our active friend able to short the market and profit? If so, was he or any fund manager able to repeat the performance by systematically gaining this market intelligence in advance of any other dramatic change in collective sentiment that drives markets in the short-term?

EMT’s view is that all of these were the result of temporary market mania and all were unable to be profited from as all were unpredictable in advance. They were the rapid revaluation of circumstance by millions of investors reacting independently to new and evolving information and no one individual was able to consistently predict when the sum total of other participants (the market) had over or underreacted.

In 1987, the total of all participants in the US market collectively overreacted to known information. As a result of these overreactions, the prices quickly recovered. In the previous great crash in 1929, the total of all participants underreacted to the information and another bigger crash was required and occurred in 1930.

The EMT postulates that around half the crashes should be too little and half should be too big for markets to be operating efficiently in the long-term. Unpredictable economic outcomes generate price changes. The distribution is around the mean — the expected return that people require to hold stocks. That distribution has outliers, sometimes too much adjustment to new information, sometimes too little but always unpredictable in advance.

Robert states that Morningstar data shows that, net of fees, the average local equity trust has beaten the All Ords Accumulation Index since 1980 by 21 per cent. I take that to mean one per cent per annum over 21 years and this can be entirely explained by survivorship bias. Robert does not state that only the above average managers would survive the 21 years and all the other horror managers drop out. This would so grossly distort the figures as to make one per cent an appalling result.

I can guarantee no-one would have been able to predict in 1980 the managers that would survive and those that would fall by the wayside. Talk about torturing the facts until they confess. Even if it were true that the average manager only outperformed by one per cent, it is an awful lot of extra risk and cost and churning to justify it. I bet none of the managers promised to outperform by only one per cent per year.

The reason the average investor consistently makes poor buy/sell timing decisions is they are constantly being advised to get into a fund that is outperforming its peers just before it regresses to the mean. There is an entire advice and research industry receiving big commissions to change investments that is perpetuating this phenomenon.

Saying markets are efficient is not saying managers are stupid. Far from it. It is because they are so good at processing all known information that there is no room to profit in advance from glaring inconsistencies. There is a capital market rate of return and that return over time will be greater with more exposure to the risk of small or distressed stocks in a portfolio. It is the cost of capital argument that has been disguised as undervalued or overvalued stocks.

More than 94 per cent of the return achieved by all market participants can be explained by their exposure to market risk, small company and value stock risk for which the cost of capital premise demands they be paid a premium.

Despite this, as long as there is a buck to be made in marketing the golden goose, the focus and expense will be poured into the minor factors of stock picking and market timing, which account for only six per cent of return, and scorn will be poured on anyone who dares to possibly say otherwise.

Kevin Bailey is principal of Money Managers,a Melbourne-based planning group.