From the Economist
THE GRAND ILLUSION
Mar 5th 2009
How efficient-market theory has been proved both wrong and right
THE past ten years have dealt a series of blows to efficient-market
theory, the idea that asset prices accurately reflect all available
information. In the late 1990s dotcom companies with no profits
and barely any earnings were valued in billions of dollars; and in 2006
investors massively underestimated the risks in bundling together
portfolios of American subprime mortgages.
There is now widespread acceptance that investors can behave
irrationally, creating very large anomalies. Take the momentum effect, the practice of buying the stockmarket's best performers over
the previous time period. A study by the London Business School found that,
since 1900, buying British stocks with the best momentum would have turned GBP1 into GBP1.95m (before costs and tax) by the end of last year; the same sum invested in the worst performers would have grown to just GBP31. In efficient markets, such an anomaly should be arbitraged away....
But it is important not to throw out all the insights of
efficient-market enthusiasts. Although it is theoretically possible to make money by outperforming the markets, it is extremely difficult in practice.
That ought to have made investors suspicious of the
smoothness of the returns of Bernard Madoff, who has been accused of a vast fraud. His strategy, as advertised, might have produced less
volatile returns than the index, but the absence of negative months
suggested almost perfect market timing.
Some fund managers have beaten the markets over long periods. The problem is to identify them in advance. Picking them after
they have outperformed may be too late, as those who backed Legg Mason's Bill Miller have recently discovered. Why is this? Fund managers are human too and subject to behavioural biases. In addition, the larger their funds become (as their reputation spreads), the more difficult it is to outperform
The temptation has also been to assume that fees are positively correlated with performance--that if mutual fund managers charging 1.5%
are good, hedge-fund managers charging 2% (and 20% of performance) are even better. Because investors cannot beat the market in aggregate, all this means is that money is transferred from investors to fund managers. Even David Swensen, the man who led the drive into alternative assets at Yale University, thinks most investors should rely on low-cost index-tracking funds