James Montier Mauls the Efficient Market Hypothesis

“The EMH also teaches us that opportunities will be fleeting as someone will surely try to arbitrage them away. This, of course, is akin to the age old joke about the economist and his friend walking along the street. The friend points out a $100 bill lying on the pavement. The economist says, ‘It isn’t really there because if it were someone would have already picked it up’.”
-James Montier

In this week’s Thoughts From The Frontline newsletter, John Mauldin brings us a special treat, one of the most comprehensive dissections of the Efficient Market Hypothesis (EMH) I’ve ever read.  The argument is actually an address that was made at the CFA UK conference by James Montier of Societe Generale.

As someone whose job it is to add value and strive to outperform on behalf of investors, I reject the EMH with every fiber of my being.  EMH is essentially the belief that the market is at all times priced for perfection and that all abnormalities and inefficiencies are immediately taken advantage of and arbitraged away.  An active manager who is more concerned with profits than with hewing closely to a benchmark would have no choice but to strenuously disagree.

I also personally dislike theological or philosophical theories that tell me that my fate is sealed and nothing I do can change the outcome or alter my course in life.  EMH is the economics equivalent to this concept.

Here is a bit of what Montier had to say on the subject:

The EMH supporters have strong similarities with the Jesuit astronomers of the 17th Century who desperately wanted to maintain the assumption that the Sun revolved around the Earth. The reason for this desire to protect the maintained hypothesis was simple. If the Sun didn’t revolve around the Earth, then the Bible’s tale of Joshua asking God to make the Sun stand still in the sky was a lie. A bible that lies even once can’t be the inerrant foundation for faith!

The efficient market hypothesis (EMH) has done massive amounts of damage to our industry. But before I explore some errors embedded within the approach and the havoc that they have wreaked, I would like to say a few words on why the EMH exists at all.

Academic theories are notoriously subject to path dependence (or hysteresis, if you prefer). Once a theory has been adopted it takes an enormous amount of effort to dislocate it. As Max Planck said “Science advances one funeral at a time”.

He also covers the intense need on the part of many managers to focus on faulty measures of risk or to obsess over benchmarks when delivering performance because of career risk:

To be honest I wouldn’t really care if EMH was just some academic artefact. The real damage unleashed by the EMH stems from the fact that as Keynes long ago noted “practical men… are usually the slaves of some defunct economist”.

So let’s turn to the investment legacy that the EMH has burdened us with: first off is the Capital Asset Pricing Model (CAPM). I’ve criticised the CAPM elsewhere (see Chapter 35 of Behavioural Investing), so I won’t dwell on the flaws here, but suffice it to say that my view remains that CAPM is CRAP (Completely Redundant Asset Pricing).

The aspects of CAPM that we do need to address here briefly are the ones that hinder the investment process. One of the most pronounced of which is the obsession with performance measurement. The separation of alpha and beta is at best an irrelevance and at worst a serious distraction from the true nature of investment. Sir John Templeton said it best when he observed that “the aim of investment is maximum real returns after tax”. Yet instead of focusing on this target, we have spawned one industry that does nothing other than pigeonhole investors into categories.

As the late, great Bob Kirby opined “Performance measurement is one of those basically good ideas that somehow got totally out of control. In many cases, the intense application of performance measurement techniques has actually served to impede the purpose it is supposed to serve.”

The obsession with benchmarking also gives rise to one of the biggest sources of bias in our industry – career risk. For a benchmarked investor, risk is measured as tracking error. This gives rise to Homo Ovinus – a species who are concerned purely with where they stand relative to the rest of the crowd. (For those who aren’t up in time to listen to Farming Today, Ovine is the proper name for sheep). This species is the living embodiment of Keynes’ edict that “it is better for reputation to fail conventionally than to succeed unconventionally”. More on this poor creature a little later.

Read the entire piece at TFTFL:

Six Impossible Things Before Breakfast

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