Crowds may not be so “wise” after all

CAPM / Alpha Theory 18 Jun 2009

A few days ago, we reflected in the rationality of closed-end hedge fund pricing.  And with markets swooning – then recovering this year, the topic of overall market rationality (or lack thereof) is firmly back on the front pages.   It seems the “wisdom of crowds” is being called into question these days.

The academics who brought us the Efficient Market Hypothesis (EMH) were recently  questioned for the website of one of their clients (Dimensional Fund Advisers).  In response to an op-ed in the Wall Street Journal by alpha-generator extraordinaire George Soros, Eugene Fama and Kenneth French argue that hedge fund managers are unqualified to comment objectively on efficient markets since they represent “a threat to their existence.”

Here’s an excerpt of what Soros had to say:

“Up until the crash of 2008, the prevailing view — called the efficient market hypothesis — was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don’t deal with the current reality, but with the future — a matter of anticipation, not knowledge.”

But Fama and French don’t buy it.  They argue that markets make “mistakes”, but they still efficient price all available information.  If their March 2009 paper on “luck vs. skill” in mutual fund management is any indication, then they’d probably also argue that Soros’ returns are a statistical aberration that is bound to crop up every now and then by chance.

Meanwhile, author Justin Fox writes a summary of his new book “The Myth of the Rational Market” (Amazon, book review) for Time Magazine this week.  Says Fox:

“In the 1990s and 2000s, in fact, this myth of the rational market was embraced with a fervor that even (Yale prof who predicted in 1929 that the market had reached a permanent plateau) Irving Fisher never mustered.”

He goes on to provide a brief history of efficient markets from Fisher to Friedman to Markowitz to Eugene Fama himself and is well worth the quick read (especially if you enjoyed the work of the late great Peter Bernstein).

The FT takes a jab at our friends from the CFA Institute (and also at virtually all business schools) for teaching efficient markets for so long.  Now, says the paper, “…the credit crisis has forced the high priests of rational market theory to question their own creed.”

The paper reports that over three quarters of the members of the CFA Society of the UK “strongly” or “very strongly” disagreed that markets are rational.  The head of the Society tells the FT that the past year has ushered in a period of “questioning” of long-held assumptions by its members.

This is a significant finding since the vast majority of the asset management industry ostensibly exists to exploit market inefficiencies (i.e. to create alpha).  While Fama and French did not specifically reference the UK survey, skeptics will surely view these survey results as a prime example of how asset managers are biased against the EMH since, as Fama and French argue, “…it’s a threat to their existence.”

Recent turmoil in global financial markets led some to predict  – as early as November – a “golden age “for hedge funds since they rely more heavily on market inefficiencies than do traditional long-only funds.  The argument goes that when market anomalies abound, hedge fund managers have the greatest latitude in arbitraging them away.  As the Economist reminded us last week:

“…one of the best periods for hedge-fund out performance occurred in the aftermath of the collapse of Long-Term Capital Management in 1998. Then, as recently, market prices moved erratically, creating anomalies to exploit.”

While two months does not make an “age”, April and May provide an initial evidence that there maybe something to this argument – and therefore that the “wisdom of crowds” may not be perfect after all.

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