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EMH and the Hubris of Active Managers

November 28, 2009

At this point, further comment on the EMH and MPT will be seen as beating a dead horse, and perhaps rightly so.  But as an inveterate dead-horse-beater of long standing, there are a couple of minor points that have been niggling away at me.  Writing them down will at least give ME closure, at the risk of annoying readers. 

Who believes the Price is Right?

There are lots of anti-EMH comments suggesting that EMH is absurd because it implied that any current market price is “right”:  how can these fluctuating prices all be correct?  Presumably by “right” or “correct” they have something more in mind than what is implied by my August 7 comment.  There I summarized the EMH as the thesis that “…investors can’t consistently beat the market over time because all available information is factored into market prices.”  This is a non-technical version of the following definition from a later edition of Sharpe’s Investments textbook:

“A market is efficient with respect to a particular set of information if it is impossible to, on the average, make abnormal profits by using this information to formulate buying and selling decisions."(1)

I tended to dismiss claims about “right prices” as some kind of misplaced enthusiasm until I ran across the enjoyable blog posting by Justin Fox (The Curious Capitalist: “Are finance professors to blame for the financial crisis?”)  Fox quotes Jeremy Siegel’s recent definition of EMH along the same lines as the two above, and goes on to imply that it’s revisionist history to suggest that these “weak” definitions ---merely that prices are not provably wrong --- were what was meant all along by the proponents of EMH and MPT.

It would be pointless getting into a major debate here about what academics generally believed, but I’m guessing that “the price is right” view of the EMH is based on a misunderstanding.  For example, in an earlier version of his textbook, Sharpe says “in an efficient market a security’s price will be a good estimate of its investment value --- that is, the present value of its future prospects as estimated by well-informed and clever analysts(2)(my emphasis).  While “investment value” sounds awfully like “correct price”, it is just the price as determined by the beliefs of influential professional analysts -- where any change in those beliefs would result in a change in price (market efficiency!) When you untangle this, it’s no different from the “weak” definitions above.  Current prices reflect current consensus beliefs, but beliefs can change in the blink of an eye, and that’s really why it’s so hard to disprove the EMH by simple counter-example.

Many anti-EMH proselytizers will reject these comments, but here’s the real point. It’s not efficient marketers who need or believe in “right” prices, it’s all of us poor benighted active managers!  It is active managers who need a concept of price or investment value that can be (at times, and for considerable periods of time) systematically different from consensus market prices, in order to justify a bet against them.  In other words, active managers need to believe that market prices can be consistently wrong -- which is just about the same thing as believing in “right” prices.

”Disproving” the EMH

You can see how slippery the EMH really is:  if current price is the consensus of current investor belief, and beliefs can change instantly and dramatically, then large price changes can happen very quickly.  Indeed it’s not large and violent price changes that can disprove the EMH, as suggested by the “price is right” argument, but rather the nature of those price changes.  Martin Wolf provides an excellent summary of this point in his review of the economist Andrew Smithers' recent new book.(3)

The efficient market hypothesis, which has had a dominant role in financial economics, proposes that all relevant information is in the price. Prices will then move only in response to news. The movement of the market will be a “random walk”. Mr Smithers shows that this conclusion is empirically false: stock markets exhibit “negative serial correlation”. More simply, real returns from stock markets are likely to be lower, if they have recently been high, and vice versa. The right time to buy is not when markets have done well, but when they have done badly. “Markets rotate around fair value.”(4)

So this approach to disproving the EMH doesn’t involve a direct claim that prices are not “right”, but rather suggests that what we might call a second-order property, the consequence of the EMH that prices should follow a random walk, is not true. Moreover the fact that prices do not follow a random walk doesn’t even imply that investors will be able to exploit them and earn excess profits.  Wolf goes on to explain:

A standard objection is that if markets deviate from fair value, they must present chances for arbitrage. Mr Smithers demonstrates that the length of time over which markets deviate is so long (decades) and their movement so unpredictable that this opportunity cannot be exploited. A short seller will go broke long before the value ship comes in. Similarly, someone who borrows to buy shares when they are cheap has an excellent chance of losing everything before the gamble pays off. The difficulty of exploiting such opportunities is large for professional managers, who will lose clients. The graveyard of finance contains those who were right too soon. (5)

If the EMH can be wrong, but the disproving of it doesn’t imply that investors can exploit pricing to make excess profits, then the EMH is very slippery indeed!

In any event, very few active managers (except some of the dreaded “quants”), would say that they based their investment approach on negative serial correlation, the crux of this “disproof”.  Most investors just assume that EMH is wrong.  Any search for present or future value beyond the veil of current prices implies that they have insights into the market (that is, correct pricing) that most others don’t have or share. If you believe the EMH you will think of this as the Hubris of Active Management.  If you are an active manager you think of the EMH as irrelevant (or probably don’t think of it at all) because it doesn’t explain the behavior of market participants.  It turns out to be an empty, if beguiling, description of pricing.  

Of course rejecting the EMH, even for the right reasons, doesn’t change the basic arithmetic fact of active management:  that "after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar."(6) So even those who reject the EMH should beware the hubris of active management.


1. Actually the first Canadian edition, an oddity from pre-free trade textbook manufacturing:  Investments, First Canadian Edition, William F Sharpe, Gordon J. Alexander, and David J. Fowler, Prentice Hall Canada Inc., Scarborough, Ontario, 1993, p. 72. (Return to text)

2. Investments, Third Edition, William F. Sharpe, Prentice Hall Inc., Englewood Cliffs, N.J. 1985, p. 68. (Return to text)

3.  Wall Street Revalued: Imperfect Markets and Inept Central Bankers, Wiley 2009. (Return to text)

4. “How mistaken ideas helped to bring the economy down”, Martin Wolf, Financial Times, October 27 2009. (Return to text)

5. Ibid. (Return to text)

6. "The Arithmetic of Active Management", William Sharpe, The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991. pp. 7-9.

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