Theory is no match for market forces

I have a theory that there are two kinds of people: those who believe there are two kinds of people and those who don’t. If you think this is a stupid way to classify people, this merely proves that you are one of the type who do not believe that there are two types of people.

Thus the theory is tightly self-contained, and unassailable to outside criticism.

My theory has something in common with Efficient Market Theory (EMT). EMT states that markets are absolutely efficient, that is, they always reflect the correct price for stocks. Normally when something is said to be ‘correct’, this means it can be verified against some external criteria or form of measurement.

But EMT does not allow external verification against any measure because the theory holds that, if the market price appears wrong against some measure, the measure must be inaccurate because the market is always right.

This makes the theory nicely self-contained. If a critic points to examples of apparently absurd market prices, such as the NASDAQ Index on a PE of 150 in the tech boom, and suggests the market was then behaving stupidly, the theory is defended not by evidence that those particular prices were indeed sound (which would be hard to demonstrate) but merely by stating that those market prices were right because the right price is always found by the market.

For an efficient market theorist, this is an article of faith.

Of course, markets have some degree of efficiency, that is, eventually they swing back from aberrant to more realistic values. Active managers attempt to add value by exploiting these aberrations — with different degrees of success.

However, EM theorists believe all such attempts are doomed. They claim it is impossible to consistently outperform a market because this implies the ability to perceive where the market has undervalued or overvalued — which, by definition, it never does. Any outperformance is chance and not sustainable. Thus EMT is seen as an argument for index funds.

EM theorists point out that the fact that some managers have produced a superior return is not inconsistent with chance outcomes.

According to this view, Warren Buffet is not the world’s best investor, but the world’s luckiest man; and Kerr Nielson and Robert Maple-Brown have also had extreme runs of good luck, which happen to have moved with them from organisation to organisation.

In my view, it requires an abandonment of common sense to believe that market prices are always efficient. For example:

n a survey showed that during the tech boom, 63 companies that changed their name to sound Internet-related experienced a price increase of on average 125 per cent in 10 days, even if they did not change their business activities at all and had nothing to do with the Internet;

n on June 30, 2001, there was a swing of 70 points in the ASX200 Index in the 15 minutes after the market closed. This was corrected within a few minutes of opening the next day; and

n on October 20, 1987, our market was 25 per cent lower at the end of the day than at the beginning.

EMT’s view must be that none of these were a result of a temporary market mania but were all equally and exactly ‘right’.

EMT assumes that the market always represents the best possible judgement of all market participants and that no individual can hope to be smarter or better informed than the mass.

Yet Morningstar data shows that, after fees, the average local equity trust has beaten the All Ords Accumulation Index since January 1, 1980 — the launch date of both indices — by 21 per cent. Before fees the margin would be greater by one to two per cent per annum. The probability against this happening by chance is enormous. This outcome is inconsistent with the theory.

Further, if it is impossible to consistently vary from an index return it must be impossible to underperform consistently. Yet, research has shown the returns produced by the average fund are greater than those produced by the average fund investor. That is, in aggregate, mutual fund investors make consistently net poor buy/sell timing decisions.

In every other sphere of life, talent and effort affect outcomes. EMT argues that, in markets, they are irrelevant and the stupid and the lazy are as well placed as the bright and hard working.

Today, the advent of the Internet is quoted as evidence that information is universally available and that it is not possible to gain an information advantage. However, EMT came into existence well before the widespread adoption of computers.

If the theory was true when first invented, we have to believe that, decades ago, it was not possible to gain an information advantage. As markets were claimed to be perfect then, they can’t have improved since.

But this is ludicrous in regard to, say, the 1960s. At that time many traders priced bonds by looking them up in a book.

If the information age is seen as a key element in the efficiency of markets, we would have to conclude that EMT was false, at least when it was invented.

But what about the future? It seems probable that the speed of information will continue to increase over the next, say, 50 years. Thus, with hindsight, it may well be seen that information flows in 2002 were relatively archaic and inefficient. Yet a key premise of the theory is that this is not so.

EMT argues that attempts to add value by active management are inherently flawed, thus the only reliable differentiator between funds is cost. Yet many fund managers who espouse EMT do not act consistently with their beliefs in that they often create an index portfolio.

Indices have their constituent shares changed from time to time, which imposes transaction costs that reduce return.

As a general rule, a lower cost strategy would be to buy a diversified portfolio of stocks at random and never change it. EMT should argue that this would have every chance of producing the same gross result, due to the random nature of returns, but would be a lower cost portfolio.

In my view, at times, markets are highly inefficient at least over the short term. Over the longer term, which can be very long, reality always intrudes. Thus, in its extreme form, EMT seems flawed as a basis for developing investment methodologies.

Of course, the fact that EMT may be flawed does not mean an index fund won’t produce a satisfactory result, or even a better than average result after costs at certain times or in some asset classes.