Thus far in this series, we’ve looked at market efficiency and management styles in a general sense. Yet, investors must examine these factors and make decisions at multiple points, including when they select an asset allocation.

A completely passive asset allocation would mirror the market portfolio, which may look something like the below. Hypothetically, an investor could construct such a portfolio.

However, some investors will want a more aggressive portfolio while others will desire a less volatile portfolio. Consequently, they will adjust their allocation weights to produce different portfolios along the efficient frontier. 

Yet, the efficient frontier is not a constant thing. Does it represent a 3-, 5-, 7-, 10-year, or some other time horizon? The efficient frontier will look different for each horizon, as seen below:

Once settled on a time horizon, investors face a new decision: should historical data be used or future assumptions? If historical data is assumed, which timeframe should be used? 100 years of data? Or just the most recent 10 years? Or a decade that most resembled our current situation? Each will provide a different frontier.

If one chooses to use future assumptions, what assumptions should be used? Rarely do people agree on what the future will look like and nobody can consistently predict it accurately. Below is an example of possible efficient frontiers, based on differing assumptions:

It’s not just average investors that cannot agree on what the future looks like. There is debate amongst the largest asset managers who have vast resources, huge budgets, and large teams of economists, analysts, and researchers. Below are the 2017 capital markets assumptions from three of the largest asset managers:

• Vanguard
• Blackrock
• JP Morgan

Regardless of whether an investor allocates to actively managed funds or passive index funds, selecting an asset allocation is an exercise in active management. In fact, allocation decisions will likely be more determinative to a portfolio’s risk and return than whether active or passive managers are used within each asset class.

Before delving deeper into the topic of market efficiency and active vs passive, it may be helpful to briefly review the definitions of beta and alpha.

Beta

At it’s simplest, beta can be defined as the volatility of an asset relative to a benchmark. The benchmark is often an index of a specific sector or an entire asset class. For example, a US large-cap stock that is 20% more volatile than the S&P 500 index has a beta of 1.2. Or if the volatility is 20% less than the index , it’s beta is .8. Beta is a measure of relative volatility.

Alpha

Within the Capital Asset Pricing Model (CAPM), this same beta is used to forecast returns. Under CAPM, higher beta leads to higher returns and lower beta results in lower returns. In other words, a fund with more volatility should have higher returns and a fund with lower volatility should have lower returns. Reality rarely unfolds as modeled, so an ex-post CAPM equation was created. It adds a variable called alpha to account for the difference between an asset’s actual return and it’s expected return (which CAPM predicts to be the benchmark return, adjusted for volatility). Below are a couple of examples on calculating alpha:

• An investor invests in large-cap domestic stocks and reports a 10% return, while the Russell 1000 returns 7%. The investor has produced 3% alpha.
• An investor invests in global equities and reports a 9% return, while the MSCI All Country World Index returns 13%. The investor has (negative) alpha of -4%.

Beta, Colloquially

The term beta is often used to refer to the risk and return characteristics of a benchmark. Some examples: US large-cap beta may refer to the Dow Jones Industrial Average or the S&P 500, investment grade bond beta is often synonymous with the Barclays Agg index, or tech beta may simply refer to a tech-sector ETF. I often refer to index ETFs as cheap, liquid beta. Some may compare large-cap beta to small-cap beta or consumer staple beta to consumer discretionary beta, when discussing risk and returns. Below are some examples of how someone might refer to beta:

• Utility sector beta is sensitive to interest rates.
• An index fund may be called beta exposure.
• An investor holds investment grade bonds and reports a -1% return while the Barclays Agg is down 3%. Some might say that the beta return was -1% (and alpha was positive 2%).

To recap:

• Beta is an asset’s volatility, relative to a benchmark.
• Alpha is an asset’s return above it’s benchmark, after controlling for differences in volatility.
• Technical definitions notwithstanding, the term beta is often shorthand for a benchmark or may refer to the benchmark’s risk and return characteristics.

Does it matter whether markets are efficient or not?

Not really and here’s why:

• As I mentioned last week, nobody knows how efficient or inefficient markets are (due to the joint hypothesis problem, eloquently summarized here)
• Asking whether a market is efficient is often a proxy for asking whether one can outperform. However, the questions are different, as we’ll see below.

Last week’s post mentioned Eugene Fama, who won a Nobel prize for developing the Efficient Markets Hypothesis (EMH). However, Jack Bogle (who founded Vanguard) also has a hypothesis called the Costs Matter Hypothesis (CMH), which he introduced here in 2003. Consider the following, which both Fama and Bogle agree on:

• In any market, aggregate investor performance will equal the overall market performance minus costs. This statement holds whether a market is efficient or inefficient. Regardless of a market’s efficiency, investors as a whole will underperform because they bear costs. To outperform the market, you must beat the market by more than your costs.
• Since total investor performance is limited to market performance minus costs, any investor’s outperformance comes from another investor’s underperformance. So to beat the market, you must also beat other participants.

Thus, the important question for investors is not whether markets are efficient or not, but whether they can reliably and consistently beat both the market and other investors net-of-fees. If the answer is yes, investors might benefit from using active management. If the answer is no, it is likely better to use a lower-cost vehicle, such as an index fund.

Of course, there is more than one market. There are many asset classes and markets, so the question of whether you can beat the market or not must be asked over and over. Each market is unique and changes throughout different environments, so the question needs to be continually asked: is it possible for me to beat this market net-of-costs?

Are markets efficient?

A finance professor and his student were walking across campus when they spotted a $20 bill on the ground. The professor advised, “Don’t bother picking that up. If it was real, someone would’ve picked it up already.” The student picks it up anyways and buys himself to a beer.

There are not a lot of $20 bills laying on the ground, but they are found from time to time. That’s the short answer. The long answer is as follows:

The term efficiency is used to connote several different ideas, but the most common one is a concept formalized into the Efficient Markets Hypothesis (EMH) by Eugene Fama, who won a Nobel prize for his work on the subject. The theory basically says that markets allocate capital best and thus value assets best (or “efficiently”). There are 3 forms of the theory:

• Weak Form: all historical information is priced into an asset’s price.
• Semi-Strong Form: all historical and public information is incorporated into an asset’s price.
• Strong Form: all historical, public, and non-public information is Incorporated into an asset’s price.

However, below are some instances when when each of the forms does not hold up.

Strong Form

• Prices often have material and sustained moves when private information is publicized.
  • Prices often move on earnings announcements or press releases.
  • The uncovering of scandals or fraud impacts prices.
• I do not know anyone that subscribes to the strong form of the EMH.

Semi-Strong Form

• Arbitrage opportunities exist fairly frequently. Although not all are actionable due to constraints and costs, enough are:
  • Closed-end funds can trade at extreme premiums and discounts to their underlying NAV.
  • We have seen public companies trading for less than the value of their stakes in other public companies.

Weak Form:

• Momentum as a risk factor has been shown to offer a return premium.
• Flash crashes and flash rallies have extreme mean reverting tendencies.

Beyond poking holes in the idea of market efficiency, the above examples represent opportunities for active managers to outperform. Yet, it is difficult for investors to outperform on a consistent basis, which implies (but does not prove) that markets are at least somewhat efficient.

So what can we conclude? That markets are not always efficient, but are probably efficient at least some of the time. This is a very unsatisfying answer, but that is okay because it is unclear whether market efficiency even matters to investors. I’ll explain why in an upcoming post.

P.S. My own view is that markets are generally efficient, although this cannot be proven. I could’ve listed more examples of market inefficiency, but they would not have been robust enough to categorically prove markets are inefficient and stand up to every possible logical critique. On the other hand, data showing that markets are difficult to beat does not prove markets are efficient, but it seems like investors would beat the markets more easily, frequently, and consistently if markets were generally inefficient.

Thus, I believe markets are generally efficient. However, efficiency seems non-existent during certain times (ie. when rationality gets thrown out the window during bubbles and panics) and in specific asset classes (where there are constraints to arbitrage, complexity, due diligence costs, transaction costs, or anything else that makes it difficult to invest easily). So my usual answer to the original question is that markets are generally efficient, but there are episodes and pockets of inefficiency.