Friday, January 4, 2013

The Future of Beating the Market

A few years ago, I got into a spirited debate with a fellow college student about efficient market theory. This particular student was a finance major and wanted to become a hedge fund manager. Needless to say, he didn't believe in EMT. Our conversation ended with something like this:
Me: Ultimately, if you want to be a hedge fund manager, then you have to believe that markets aren't efficient. It's either that, or you want to scam rich people for a living.
Him: Pretty much, yeah.
Efficient market theory states that all relevant information has already been considered and priced accordingly by the market. If this is true, then any individual investor can't consistently outperform the market because rational investors cannot come to a conclusion that is radically different from what market has concluded (because two rational actors can't look at the same information and behave differently) and irrational investors by definition can't consistently outperform anything.

This theory is anathema to just about everybody in the wealth management industry. Because if everybody believed in it, the lucrative fees and commissions that the finance industry generates would be eliminated. But that won't happen. There will always be smart people in sharp suits trying to tell other people that they have the intelligence, pluck, and savvy to make more money than the other guy.  And there will always be people with money who are all to eager to believe them.

But it seems like the tide is slowly turning. More and more investors are pulling money out of actively managed funds and putting them in passive funds. This is mainly driven by the low fees that index funds are known for. Because following an index requires no human thought (and therefore very little human labor), the fund manager's role is minimal and therefore cheap.

But perhaps investors still don't believe in EMH. Because index funds can track any kind of index, investors could be purchasing index funds that track more exotic indices rather than vanilla indexes like the S&P 500. So if the goal is to consistently outperform the broader market (with the S&P 500 index as an approximation), investors might be pouring money into funds that only tracks a particular segment of the market and then shifting preferences as market conditions change.

It's conceivable that the future of actively managed funds would be nothing more than fund managers trying to buy and sell the right ETFs to capture outperforming market sectors at the best possible time, instead of picking individual companies. Although everybody always advises other people that "you can never time the market consistently", it seems like that rule doesn't apply for themselves.

Benjamin Graham is now taken for granted, and everybody else is searching for the extra edge on top of fundamental analysis. Because knowing the fundamentals won't deliver outsized returns anymore since everybody else already knows the fundamentals. It could be that everybody builds on top of fundamental investing, long the bedrock of modern investment theory, and incorporates macroeconomic principles and game theory into investment strategy.

Or maybe that's already happened and academia hasn't incorporated it into a named theory yet. One thing's for sure. As long as people don't believe in efficient markets, it makes markets more efficient.

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