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Is the Market Efficient? Cliff Asness Says Yes, and No

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Cliff Asness created a “watershed moment in the hedge fund industry” when he brought his sophisticated hedge fund strategies into the mutual fund space in 2011, said Scott Burns of Morningstar in introducing Asness last week.

Asness created a similar moment in his morning keynote speech at the Morningstar Investment Conference on Friday, exploring whether the markets are efficient in his trademarked sophisticated manner, bolstered through the display of high-end research and peppered with humor. He began by apologizing for “talking about theory at 8:00 a.m.” to a receptive audience before presenting his take on why the Nobel prize committee was correct in awarding its economics prize last year to two men who sit on opposite ends of the efficient market theory: Eugene Fama of the University of Chicago and Robert Shiller of Yale (Asness also made sure to honor the sometimes overlooked third winner of the prize last year: Lars Hansen, also of Chicago.).

“Gene and Bob are on opposite sides of the efficient market hypothesis,” Asness said, before disclosing that he’s “not exactly unbiased,” since he not only was a student of Fama’s at Chicago but his teaching assistant as well for two years, and that “along with Jack Bogle he’s one of my investing heroes.” But his bias, he said, was “at least in both directions.” He also noted that his Ph.D dissertation at Chicago for Fama argued in favor of the price momentum strategy — “that it worked” — but that Fama was gracious and supportive despite their differing beliefs.

Invoking an article he wrote with John Liew for the March 2014 issue of Institutional Investor, Asness said that “I also think markets work very well (not perfectly) most (not all) of the time,” but also that “I try to beat the markets on a daily basis (and at least somewhat for ‘behavioral’ reasons),” which would put him in the camp of Shiller, who argues (pardon the dumbing down) that it’s human behavior that moves markets, not the universal information that is shared by all market participants. Or as Asness relayed Fama’s 1991 definition of the EM hypothesis (EMH): “I take the market efficiency hypothesis to be the simple statement that security prices fully reflect all available information.”

Asness said that his bottom line that he’s “learned to live with my schizophrenia,” saying “I’m not a super-hardcore efficient marketer.”

Putting on his eyeglasses to read his slides on what an efficient market is and what it is not, Asness said “I’m putting on glasses; they’re not sunglasses” — a sly reference to Bill Gross’ shades-wearing performance the day before at Morningstar — drawing a big laugh from the crowd.

Among the things that an efficient market hypothesis is not, Asness said, is a belief that security returns are normally distributed; that it’s an argument for “stocks for the long run, or a love of equities,” or an argument for the free markets, or that the capital asset pricing model (CAPM) is the right model.” The problem with the EMH-behavioral finance argument, he said, is threefold:

  • You can’t directly test the Efficient Market Hypothesis (and he said in passing, “the CAPM “does not work”)
  • To determine if security prices “fully reflect all available information,” we need a model that says how prices are supposed to reflect this information.
  • Thus, any test of market efficiency is a test of the joint hypothesis of market efficiency plus whatever pricing model you’re using.

“No one believes the entire tech bubble was rational,” he argued, before digressing to say that “‘bubble’ gets way overused; we use it to describe something we don’t like,” and then saying about the current U.S. stock market that “I’d call it a lower expected rate of return” market, but “not a bubble.”

Fama himself teaches that “the markets are almost definitely not perfectly efficient,” Asness said, because of the “limits of arbitrage.” He then quoted Keynes: “Markets can stay irrational longer than you can stay solvent.”

He then turned to the real world of investors and what’s the best way to invest. “The average stock picker thinks the market’s pretty inefficient,” he said, quoting Upton Sinclair: “it’s difficult to get a man to understand something when his paycheck depends on him not understanding it.” Instead, markets do behave “in some cases because they’re efficient — but it’s mostly in the middle.”

Most individuals “would be better off acting like the market was perfectly efficient” and investing in index funds along with his hero John Bogle,” since “active management is hard, and so is deviating from the market,” referencing again Keynes’ statement that the market can stay irrational longer than you can stay solvent.

If markets are not perfectly efficient, he said, then “you have to worry about regulation, accounting and liquidity.” Making the case further for active investing, he said that there are “real anomalies to the market — indexing is not the only portfolio worth holding. You can be an indexer and beat the market just on fees, or you can do some sweat equity and do better.”

But as far as Fama vs. Shiller, he concluded that “I thought Nobel committee was right to make the dual award.”

As for the audience’s receptiveness to Asness, one attendee tweeted: Dr. Clifford Asness is giving one of the best presentations I’ve ever heard. is going to get some awesome flows from this.”

Even at 8:00 in the morning.

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