The Origin of Species

CAPM / Alpha Theory 21 Aug 2008

Melvyn Teo’s paper on the relative merits of locally-based Asian hedge funds vs.  those with no local presence (see yesterday’s posting) amounts to a significant indictment the Efficient Markets Hypothesis.  After all, why would one group of managers (i.e., those without a local office) be willing to forgo higher returns?  And why wouldn’t investors just stop investing in sub-optimizing, apparently irrational funds?  It’s as if these two groups were totally different species or something.

And indeed, they may be different species – in a sense.  Back in 2004, MIT’s Andrew Lo, the author of a huge library of refreshingly easy-to-read papers and articles, proposed a successor to the EMH that actually defined different groups of investors (pensions, individuals, traders etc.) as different “species” of investors and expanding on the biological analogy.  His resulting Adaptive Markets Hypothesis (AMH) explains the apparent irrationality of markets as a rational reaction to a change in environmental conditions.   His Journal of Portfolio Management paper can be downloaded here (academic version available here).

Drawing from behavioural finance, Lo says that investors make decisions using heuristics drawn from trial and error, not from concrete analytical models.  Drawing a page from Darwin, he says that without adequate trials and errors, there is no adaptation.

He supports Joseph Stiglitz’ famous conclusion that perfectly informationally efficient markets are technically impossible since someone somewhere has to exploit some kind of arbitrage opportunity in order for an equilibrium to be reached.  Lo adds:

…the degree of market inefficiency determines the effort investors are willing to expend to gather and trade on information.

There’s little doubt that smaller markets (e.g. in Asia) are less efficient than larger, more mature markets like the US.  So you’d expect investors to be willing to expend a lot in order to uncover investment opportunities.  And indeed, you do.  As Teo found in his study, investors are essentially willing to pay foreign funds a premium (via sub-optimal returns) in order to exploit the inefficiencies inherent in these markets.  However, unlike Lo’s version of events (where investors are willing to expend their own efforts), they are doing it vicariously through their non-local fund manager.  Whether the fund manager re-deploys this expenditure in the form of greater research effort is another question altogether.

As for why the anomaly identified by Teo doesn’t arbitrage itself into oblivion, it appears that the sheer size of the irrational beliefs of US and UK investors may be enough to trump the otherwise ubiquitous effect of market forces.  As Lo said in his seminal 2004 article:

…this last conclusion [that ‘the impact of irrational behaviour on financial markets is generally negligible’] relies on the assumption that market forces are powerful enough to overcome any type of behavioural bias, or, equivalently, that irrational beliefs are not so pervasive as to overwhelm the capacity of arbitrage capital dedicated to taking advantage of them.

Perhaps as anomalies like Teo’s propagates through the hedge fund community it will disappear.  But for now, it would appear that there hasn’t been quite enough “trial and error” for investors to discard their heuristic that you can manage an Asian hedge fund from Mayfair or Midtown.

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