March 17, 2014

The Great Divide over Market Efficiency

In a recent Institutional Investor article, authors Clifford Asness and John Liew, offer an interesting and entertaining look at the evidence for and against market efficiency.  Their article takes turns on both side of the debate by highlighting the strengths and weaknesses of work produced by two recent winners of the Nobel Prize in Economics, Eugene Fama and Robert Schiller.  Fama’s work on the Efficient Market Hypothesis established the foundation for the growth of indexing strategies while Shiller’s famous call of the technology bubble and work in behavioral finance has made him a leader in the debate for viewing markets as inefficient.

The article, while presented in a reasonably balanced manner, is authored by hedge fund managers whose livelihood depends on their ability to beat the market.  One area they touched, but failed to dive deeply on, is that arguments about whether or not the market is efficient are likely pointless for most investors.  The relevant points are that, empirically, low-cost, indexing strategies outperform the vast majority of active managers over time and predicting who the few outperformers will be beforehand is exceedingly difficult.

These facts suggest that, efficient or not, the best approach to stock market investing is centered on low-cost, low-turnover exposure to priced market risk factors.