How to Beat an Efficient Market

. August 13, 2011
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Imagine a perfectly efficient market. In this world, no human manager will consistently beat a properly diversified portfolio over time.

Even if the real-life market were efficient, and I don't think is is, you can still beat it. The key is in how people define the word market.

My Argument with a Stock Broker

Eugene Fama (left), father of 
the efficient market hypothesis
I recently had to attend one of those meetings where a financial company presents portfolios that are supposedly optimized for your age. It was the usual pitch about how most of your money should be in stocks when you're young and bonds when you're older.

I raised my hand and asked if there were ways to capture value from strategies other than buying and holding stocks: for example, momentum and volatility arbitrage. The speaker started saying how this was a very aggressive approach to investing when I interrupted and asked, "How is it aggressive? These strategies are not correlated with the S&P 500."

He said, "Yes, they are." And that was the end of my opportunity to ask questions.

Talking to him afterward, I found out why he thinks my strategies are aggressive. None of the funds his company offers has significant short exposure to the market. There is no protection for their 'optimized' portfolios when the market goes down.

Why don't they offer a broader array of funds? His said that investors will misunderstand and misuse the funds. Rather than risk getting sued, his company prefers to not offer the funds at all.

This is perfectly rational from their point of view. It would hurt both the company and their clients if they were sued. It's better to offer the same underperforming products as everyone else. If the market crashes and everyone loses money at the same time, they can chalk it up to bad luck.

Managers Can Best Each Other

Now consider an efficient market. There will be some benefit to having exposure to trading strategies as well as stocks, bonds, real estate, and commodities. There will be an ideal, perfectly diversified portfolio that a human manager will not be able to add any value to. But a manager can still add value relative to another manager if the other manager is not diversified enough.

I've written previously about a long-short momentum strategy that not only makes money when the market goes down, it has zero correlation with the S&P 500. The stock broker described earlier thinks momentum is risky because his company's philosophy doesn't allow him to go short. If he tries to trade momentum, he has no way to protect his clients if the broad market goes down. In other words,

"Since all the strategies we're allowed to use are risky, your strategies must be risky, too."

Most managers you meet will be like this. Because they're scared of being different from everyone else and consequently getting sued if something goes wrong, they're going to put you in 50% U.S. stocks, with most of the rest in U.S. bonds, with small slivers of exposure to international stocks, real estate trusts, and commodities.

Even from the point of view of a buy-and-hold investor, this is under-diversification. Real estate investment trusts have historically not been strongly correlated to stocks. Commodities have had zero correlation to stocks. Why don't they comprise a larger portion of the 'optimized' portfolio?

Be Willing to Diversify

You can best the vast majority of money managers simply because you're willing to diversify across asset classes and trading strategies. You can beat the market simply because the industry has conveniently defined the 'market' as the S&P 500, which is an under-diversified index of large-capitalization American stocks.

Mebane Faber's portfolio beats the 'market' because it diversifies in two ways most people don't:
  • into more assets (commodities and real estate investment trusts as well as stocks and bonds), and
  • into a momentum-based trend-following strategy.
His book, The Ivy Portfolio, is worth reading.

This post was inspired by Jez Liberty's read-worthy blog post about a new S&P trend-following index. The comments section has an interesting discussion about whether human trend-following traders still add any value if investors can access trend-following strategies through well-known formulas.


Jez Liberty said...

Hey Reformed Trader - nice post and thanks for the mention...