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.

Part of the reason I write is to articulate various frameworks and positions that are in my head. Many people ask me similar questions too, so hopefully I can just refer them to the blog in the future. That being said, I’m going to kick-off a multi-post series on the oft-misunderstood concepts of market efficiency, low-cost investing, index investing and passive management.

Despite the growing popularity of index investing (which I highlighted last week):

• Active managers still manage the majority of assets under management (AUM).
• Many investors’ think that they or someone they hire can beat the market.

On the flip side:

• Many investors’ conflate market efficiency, indexing, low-cost investing, and a host of other concepts.
• Many passive investors overstate the case for market efficiency and/or index funds.
• Some investors have a blind faith in market efficiency and/or passive management.

Adding to (or abetting) the confusion is a financial services industry that markets and promotes a wide range of approaches. It can be difficult to find unbiased answers and construct a framework without researching these topics yourself. My goal for the next few posts is to provide some answers in a concise way.

Fund flow data consistently shows that dollars have been moving from actively-managed funds to passively-managed funds over the past decade. Beyond seeing the data every quarter, the shift has been evident in the conversations that I have.

Ten years ago, most of the clients that I spoke to were skeptical of index mutual funds and ETFs. I’d have to explain the rationale and evidence supporting index funds.

Five years ago, it was a toss-up whether new client conversations would be spent explaining why we primarily used index funds or explaining why we also had exposure to some higher cost active funds.

These days, new clients are often quick to understand and accept the indexed parts of portfolio recommendations, but I have to explain why specific active funds make more sense for parts of a portfolio.

Although index funds are not always best and certainly not for all parts of a portfolio, they often are the best choice and rarely a terrible choice. Thus, I think greater investor awareness and acceptance of index funds is generally a good thing. It’s been interesting to watch the migration.

Over the past few weeks, I have seen and heard evidence of increased competition in both public and private credit markets. As valuations rise and prospective returns decline, I think it wise to remember Thiel’s mantra of avoiding competition. Just as businesses do best in the absence of competitors, investors perform best when they do not have to compete for opportunities.

“Competition means no profits for anybody, no meaningful differentiation, and a struggle for survival. So why do people believe that competition is healthy? The answer is that competition is not just an economic concept or a simple inconvenience that individuals and companies must deal with in the marketplace. More than anything else, competition is an ideology—the ideology—that pervades our society and distorts our thinking. We preach competition, internalize its necessity, and enact its commandments; and as a result, we trap ourselves within it—even though the more we compete, the less we gain… If you can recognize competition as a destructive force instead of a sign of value, you’re already more sane than most.

-Peter Thiel, Zero to One

Just now catching up on highlights from last week’s Berkshire Hathaway annual meeting, which is always full of wit and wisdom from Buffett and Munger. The above quote is my favorite from this year’s meeting and is pretty consistent with what Munger and Buffett have been saying for years about the importance of intelligence versus sober thinking.

On IQ:

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.” -Warren Buffett (via Wiley)

 

“Success in investing doesn’t correlate with I.Q. once you’re above the level of 125. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” -Warren Buffett (via Pensions & Investments Online)

On Rationality:

“It is remarkable how much long-term advantage people like [Warren Buffett and myself] have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” – Charlie Munger (via 25iq)

Lastly, one of my favorite Munger stories (via WSJ):

“In the late 1980s, [Munger] recalled in a magazine interview, a guest at a dinner party asked him, “Tell me, what one quality accounts for your enormous success?”

Mr. Munger’s reply: “I’m rational. That’s the answer. I’m rational.”

 

A classic from Carl Richards, at Behavior Gap. I see it everyday on my office wall, but I still like to post it from time to time.

At a recent conference, I was reminded that definitions in the “alternative investment” space can be ambiguous and sponsors/managers are more than willing to slap the “alternative” label on nearly any investment product for marketing purposes.

One of the most helpful lessons I learned about “alternative” investments was that there is no such thing as an alternative asset. Every investable asset is either equity or debt. Let’s look at some common assets:

Stocks = equity in a company
Bonds = debt owed by a company
Real Estate = equity in a land or building
Mortgages = debt owed by a real estate owner
Commodities = equity in a physical asset

*Derivatives could technically be classified as a third category, but they will “derive” their value from equity or debt and can behave like either depending on the structure.

So the most important thing to know about alternative investments is that there’s no such thing. “Alternative” describes an asset’s place in a classification system, but not an inherent attribute. Hybrid assets, structured products, hedge funds, private equities, infrastructure, and so on can all be disaggregated into equity and debt. So before investing in an “alternative” investment, throw out the alternative moniker and understand what exactly the investment is and how it will behave. This simplified framework has been invaluable to me and I hope it is for you too!

“We don’t go on vacations. We go on your field trips.”  -my wife, pictured above in Habana Vieja

[a repost from FB, based on the positive feedback I received and the fact that many of the below points are economic in nature]

I’m going to channel my inner Tren Griffin and share 12 things that I learned in Cuba, based both on my observations and on the handful of conversations that exceeded 15-30 minutes. A small sample size and subjective, so take it for what it’s worth. However, I tried to ask different people many of the same questions for corroboration and to understand the nuances and variety of perspectives.

1. Almost everyone works for the government and earns $20-40 per month, which is not enough to cover basic needs in Cuba. I start with this fact because it has many implications and helps explain many of the following points.

2. Many people steal from their jobs to survive. If you buy 4 cups of rice, you’ll only get 3 cups. If you buy a bottle of cooking oil, it will only be partially full. Everyone accepts this. The missing amounts are sold by employees to supplement their meager incomes. Other people operate side businesses by reselling the stolen goods or black market goods brought in on commercial flights (like Colgate toothpaste, which is much better than what can be found in stores).

3. The government provides free education and medical care. The general consensus seems to be that it was decent until the USSR (and it’s subsidies) collapsed. The quality of education and medicine is pretty low and one person said that teachers and doctors will provide mediocre service unless paid under the table.

4. Service is generally slow and terrible/non-existent. Since the government runs nearly everything, there is very little competition or profit-incentive, and everyone gets paid the same regardless of skill or effort. Many Cubans lamented how lazy this makes the majority of employees. Service at private businesses is markedly better, to the point that you can pretty easily distinguish a government-run business from a privately-run one based solely on quality of service.

5. There is a serious lack of resources. People complain that they cannot find the basic things that they need. They may spend a few hours per day visiting multiple stores before being able to find basic staples like rice or oil. Most stores I saw just had empty shelves. Even as a tourist eating at the most expensive restaurants, many menu items were often unavailable (a couple of times there were only one or two dishes available, out of a menu of 10-20 items). We had a couple great meals, but the food quality was pretty low overall.

6. American tourists are flooding the island. Flights from the US started just a few months ago, but it’s already bringing an unprecedented number of tourists. People shared that they have never seen the numbers of visitors that they’ve seen in the past few months. There is a consensus that US tourism will be massive, but there also seems to be a lot of fear of what changes it will bring. While tourism is booming, so is food and rent inflation. The business owners I spoke to said business is better than ever and exceeding all expectations. Yet, they also shared that Cubans are getting priced out of housing, goods, and services.

7. People do not keep their money in banks. For one thing, Cubans are worried the government may confiscate or revalue the currency (which is roughly pegged to USD). Technically, it’s only legal to exchange currencies at official exchanges, but many Cubans will offer better rates for hard currencies on the black market so they can accumulate currency that will hold its value better (both the exchanging and owning of foreign currencies is illegal for Cubans). Secondly, bank tellers will ask for the source of any deposits. Since the majority of people’s income is from black market activity, they cannot deposit funds in the bank.

8. Wealth is not flaunted. In fact, it’s deliberately hidden. If a Cuban took multiple day trips or overnight trips around the country (like we did), the government may knock on your door, interrogate you and investigate the source of your money. Even licensed private business owners keep a very low profile. All expressed a fear that success would bring attention and that the government would shut down their business. Many people mentioned that they are starting make more money, but they cannot enjoy it at all for fear of bringing attention to themselves.

9. Despite the progress, people are not as optimistic or confident as I expected. Everyone I spoke to mentioned that although things are improving lately, the government can roll all the reforms back in an instant. They’ve done it before and they may do it again.

10. Despite the party line, there is an economic hierarchy and racial issues. I spoke to someone that said they didn’t like black people. I spoke to a black person who said he’s been discriminated against.

11. A couple people mentioned the old, fat men that come to Cuba for young girls. Both mentioned an hour costs $20, which I took to mean that it’s common enough that the average person knows the standard price. One person pointed out a schoolgirl walking by and said “She’s looking for men.” The girl looked like normal adolescent kid in a school uniform and I asked how they could be sure. “Do you want me to prove it?” my acquaintance replied. I passed.

12. There is clearly a wealth gap between Cubans and foreigners, but nobody tried to guilt us or ask for money. We did pay foreigner premiums and people took commissions for helping us arrange things, but we only ran into one insistent tout/jintero and two people asked me for food. We did see many street performers attempting to earn money. Cubans are proud and not looking for any handouts, IMO.

People were very friendly and happy to chat. I feel fortunate to have visited and met so many people. Although I probably won’t visit again, I had a good time and learned a lot.  Viva Cuba!