01 Feb 2012

Heads EMH Wins, Tails Its Opponents Lose

Financial Economics 28 Comments

More circularity posing as profundity from Scott Sumner on the Efficient Markets Hypothesis (EMH):

The past five years should have been an absolute gold mine for the anti-EMH types that supposedly dominates the hedge fund industry. Just think about it. Shiller says stocks are way too volatile, and the US stock market has been incredibly volatile since 2007. No need to worry about the market staying irrational for too long, the long run adjustments occurred quite rapidly. Then we had the mother of all housing bubbles in 2006, another great opportunity for people to rake in profits from market inefficiency. The year 2008 should have seen extraordinary profits to the hedge fund industry, with all that “irrationality” being corrected. Instead they lost more than they’d made over the previous decade.

OK, so if I understand Scott’s argument, it runs something like this:

(1) Hedge funds tend to be dominated by people who don’t believe in the EMH.
(2) If hedge funds do poorly, it means the EMH is true.
(3) Hedge funds did poorly in the last five years.
(4) Therefore the EMH is true.

So if that’s right, then if we could find a period where hedge funds did very well–as in, they beat other sectors of the market–then that should be an argument against the EMH.

Well, we do have such a period, from 2000-2007 or so. I know about it, because Scott discussed it about 3 paragraphs earlier in that same blog post.

As I pointed out in one of my favorite articles, “Economists Can Be Hilarious,” the EMH is a tautology, it’s a way of viewing the world. When Wall Street is doing great, believers of the EMH will say, “See? You can’t beat the market. These hedge funds have physics PhDs and supercomputers running crazy algorithms that squeeze every last ounce of arbitrage out of mispricings. Don’t even try to compete with these boys, just put your money in a mutual fund.”

Then, when the market crashes and all the hedge funds blow up, the believers of the EMH say, “See? What’d we tell you? It’s really hard to beat the market, even these billionaires can’t do it. Just put your money in a mutual fund.”

Last point: I’m not even saying the EMH is a bad pair of binoculars to wear, or that Sumner’s worldview is bad. I’m saying, Sumner thinks he is being empirical, when in fact no matter what happens, he will see his “theory” passing with flying colors.

P.S. Gene Callahan has a good critique of Scott’s post too.

28 Responses to “Heads EMH Wins, Tails Its Opponents Lose”

  1. Max says:

    It’s not an equilibrium for any sector to have an abnormal return, since capital will flow there to equalize the return across investment opportunities.

    That includes the hedge fund sector.

    Therefore, hedge funds can’t “beat the market” regardless of how inefficient the market is. Market inefficiency determines the size of the hedge fund sector, not the return.

  2. Strat says:

    We don’t live in equilibrium. The role of market participants is to equilibrate.

    Under EMH its very difficult to under perform as well, you have to be consistent.

    I’m pretty sure, historically speaking I can find bad investments that aren’t a pure probabilistic event gone wrong.

    • Tel says:

      Hmmm, there would surely be some market participants who pull in a bigger profit by ensuring the system remains far from equilibrium… ?

      • Strat says:

        Ofcourse, they hold back competitors, and then they themselves equilibrate (inside trading laws.) Or they trick other investors into excess demand (rumours and fraud.)

        But to profit from taking goods from high demand/low supply and put them back in at low demand/high supply isn’t profitable.

  3. Christopher says:

    The way I understand this quote is more:

    1. People are accusing hedge funds of abusing market inefficiencies
    2. EMH was never more in question than over the last 5 years so if allegation under 1. were right hedge funds should have performed very well instead they performed awfully
    3. Hedge funds are not abusing market inefficiencies

  4. Tel says:

    Just put your money in a mutual fund.

    But then again, believing in EMH automatically implies believing that no spruiker out there will ever tell you thr truth. After all that guy maximizes his profits by creating a gap between what he knows and what you know.

    • skylien says:

      Exactly, now you know why you should not trust those guys like Marc Faber, Jim Rogers, Mike Maloney, Peter Schiff, Kyle Bass etc… Those are egoistic profit maximizing crooks. The only ones who can be trusted is the likes of Bernanke and the government. They have no profit motive. So let’s buy 5 year T-bonds at a P/E ratio of about 138, or 2 year bonds at P/E of 454! If that’s not a bargain… Only Japan and Swiss bonds (2 year Swiss bond P/E is at awesome 5000!) are even better regarding their “return” now…

      • Tel says:

        Ha ha, I’m way to paranoid to believe any of those guys

        As for T-bonds, I’m not looking at the P/E ratio, I’m looking at the trend vs AUD. If anyone wants to offer me a loan denominated in USD, I’m offering 5%

        • skylien says:


          Is that not enough for Australian banks, or is it because of lacking collaterals?

          A real paranoid tinfoil-hat wearing freak might look at the historical data of US government debt and bond rates and would ask himself: Isn’t it strange? When 30 years ago government debt was very low bond rates were compared to today insanely high. Now as time moved on the debt load increased while rates fell. Isn’t that perverse? That’s like a fruit seller increasing prices as his fruits are rotting.

          The only way this was possible is if the government itself had control/influence on bond rates. This way they could not only ensure to keep debt financing under control, this way they could manufacture the perfect bubble, because all bonds already in the market of course increase in price with falling rates so people would keep on buying and holding them. But what happens if you approach the zero bound? Even if it is not manufactured the situation doesn’t really change…

          • skylien says:

            A nice fitting article by PIMCO’s Bill Gross:

          • MamMoTh says:

            Treasury bonds are just an interest rate maintenance account at the Fed, who has been able to set the interest rate since going off the gold standard.

            Bill Gross is clueless. He’s been talking nonsense about government bonds for years, ans losing money on his positions.

            Time to understand reality before discussing it!

            • skylien says:

              I read Mosler’s articles. And I think I understand what he says there. I disagree though, a bond is not just an “interest rate maintenance account at the Fed”. It first of all is a product that has to appeal to customers. And if lots of former customers start to think that its marginal value is below the marginal value of competing (non-interest rate maintenance account at the Fed) products then what do you think will happen?

              I know that Bill lost money last year, that doesn’t prove him automatically incorrect. If that was a proper way of reasoning then from the point of view of 2006, all people who did bet against the housing market already in 2005 were wrong and therefore clueless too.

              • MamMoTh says:

                A bond can’t be anything else than an interest rate maintenance account at the Fed as a point of logic.

                The only competing USD denominated asset is a reserve account at the Fed with interest.

                They are basically the same thing with some technical differences, but in both cases the Fed sets the rate.

                Low interest rates can affect negatively the exchange rate which could help in reducing the trade deficit, or increase the value of other financial assets like gold which doesn’t really matter because it only concerns those participating in the Ponzi scheme.

              • skylien says:

                “The only competing USD denominated asset is a reserve account at the Fed with interest.”

                Uhm, you cannot exclude stocks, index funds, corporate bonds, foreign denominated assets and commodities.

                “or increase the value of other financial assets like gold which doesn’t really matter because it only concerns those participating in the Ponzi scheme.”

                Of course it matters to T-bondholders if commodities rise! That’s exactly what is determining the marginal value of a T-bond!

                You told me that even you invested in Gold. Now tell me why did you decide for Gold and not for T-bonds? Why was the marginal value for saving in Gold higher for you at that time than saving in T-bonds?

              • MamMoTh says:

                Whoever wishes to save in USD can only do it in cash, reserves (checking account at the Fed), or Treasury bonds (savings account at the Fed) and everyone can choose the portfolio mix that suits you the best. But they have nowhere else to go.

                Other financial assets will be priced at their indifference level wrt government liabilities. Always have and always will.

                What’s the problem?

              • skylien says:

                No, you do not have to save in USD. That’s the whole point! You can avoid USD, T-bonds and FED reserve accounts (only banks and governments can have BTW).

                What is the indifference price level of an ounce of Gold? Was it 300USD in 2001 or is it now 1750 USD in 2012? Please explain how this didn’t make a difference if you had to choose one form of saving in 2001?

              • MamMoTh says:

                Someone has to save those USD, there is no way out. It’s just a matter of who does it, and for how long.

                When people exchange gold for USD denominated liabilities they are both better off right? The price of gold has basically no effect on the real economy, so why bother?

              • skylien says:

                You told me that T-bonds do not have any competition. Now you try to explain to me that if someone buys Gold he does it with USD… Well, yes that’s the currency right now. Does that mean that savers don’t face the point when they have to decide how they want to save their say 500 USD earned this month? Does that mean no matter what they decide for it doesn’t matter for them or the economy as a whole? Tell that to all those who saved in houses pre 2008, or in stocks pre 2000, or in Greek T-bonds pre (maybe) march 2012, or in Weimar Deutsch Marks pre 1921, or in cash most of the time in the last 100 years…

                Depending on their decision this has very real effects on the economy as well. If he chooses to stay in cash, then this has price deflationary effects on the economy. If he goes in Gold, the price of Gold will go up and economic activity in the Gold sector rises, if he goes in T-bonds it will have effects as well. And especially if a lot of savers move from one form of saving to another because the former was tremendously overvalued (=Bubble) compared to others this will have an equally tremendous effect on those parts of the economy if not on the whole economy.

                You have absolutely no idea of value! People/markets seek highest value. T-bonds are just another form in which you can save with certain characteristics, at times it is undervalued and at times it is overvalued. No value can be guaranteed by any decree or wishful thinking. T-bonds are no exception! If your spreadsheet thinking would work the way you think, no one could ever make any loss with saving.

              • skylien says:

                “People/markets seek highest value.” That’s a bit poorly worded. I mean they seek value. That means in practice people always look for the undervalued asset, that according to their individual knowledge would have to be valued higher by the market as a whole and which has the potential of being realized by the market as a whole in the future. In any case they are not looking for the most overvalued asset/commodity…

            • Jon O. says:

              Total Return has a quarter trillion $ under management and has outperformed its benchmark over the last decade by about 2000 bp.

              WTF have you done?

          • Tel says:

            Plenty of collateral, the Aus banks charge around 7% at the moment, even for very solid borrowers. Check a few websites if you are interested.

            It’s a strongly regulated environment, and the RBA can significantly influence rates because all interbank transactions must go through the RBA clearing system. I suspect there’s a number of points where tax is siphoned off as well — the financial industry in Australia pays a lot of tax, and it has to come from somewhere.

  5. jjoxman says:

    I see a potential misinterpretation of EMH that I’ll try to head up. EMH isn’t really binary, as in markets are either efficient or they’re not. Efficiency is a spectrum – as markets have more participants they become more efficient.

    Efficiency also comes in three forms: weak, semi-strong, and strong. Weak form means that a market participant cannot use historical information to earn consistently abnormally high returns. Abnormal means higher than expected given the risk faced. Weak form essentially is stating the technical analysis will generally not be able to create abnormal returns.

    Semi-strong efficiency means that no public information, past or present, can be used to earn abnormal returns. This would mean value investing (a la Buffett) cannot be used to generate abnormal returns. Market ‘anomalies’ like the small-firm effect are included here.

    Strong form efficiency means no information, public or private, can be used to earn abnormal returns. This implies even insider trading cannot be used to generate abnormal returns. No one believes in strong form efficiency.

    In a very important paper called “The Limits of Arbitrage” (1997) Andrei Shleifer and Robert Vishny wrote about the practical difficulties that impede market participants from arbitraging away profits and thus also reduce market efficiency. For example, small firms are also quite illiquid, so it is difficult to trade their stocks. For efficient prices to obtain, trading has to be perfect liquid and immediate. In Finance, liquid means you can trade any amount of shares without affecting the price of the stock.

    Many value firms become ‘value priced’ because they are ignored by analysts and institutional funds. And it turns out that the value premium may actually be a liquidity premium because of thin markets.

    Now the hedge fund issue is interesting. For markets to be efficient doesn’t require people to believe they are efficient. It’s like God – God doesn’t need you to believe in Him to exist. I’ve read a great many studies about hedge funds and returns, and nearly all studies suffer from the same problem: hedge fund data is profoundly biased because it is all self-reported, and only the hedge funds that earn above-average returns can be expected to report their results. The ones that suck up the scene fail and close up shop. Find a data set on hedge funds that is complete without survivorship bias, and then we’ll talk.

    Some recent work has come out that tries to get around these issues with more complete data, and those are interesting. But the important part is that it’s not clear whether there is any alpha (abnormal returns) or if it is just changes in beta (risk).

    Finally, generating some alpha in one year doesn’t mean you can use the same mechanism to generate alpha in the following year. The size effect disappeared once people discovered it existed. That’s efficiency.

    • marris says:

      Thanks for for the detailed explanations. Can you recommend some good financial econ blogs? I checked out yours. It is very good.

      The semi-strong/strong boundary is interesting.

      Fama was on econtalk this week (http://www.econtalk.org/archives/2012/01/fama_on_finance.html). He mentions that it is always possible to do better than the market if we *had* better information, but EMH advocates believe the market is structured so that (1) the cost of most information is very low (so all participants have it), and (2) the cost of acquiring better information rises to prohibitive levels very quickly (so it’s not worth buying it).

      If EMH depends on this cost structure, then whether it applies seems to be an empirical question (and not tautological). For example, it may be possible to construct an inefficient market (e.g. a cartel of insiders that share a lot of information freely but change a high price to outsiders, low costs imposed on Congressional members who trade on inside info).

      There may be good economic arguments that some of these are not likely, such as Rothbard’s discussion of voluntary cartel instability in MES, but we need to see what structures are out there.

      • jjoxman says:


        Thanks for reading my blog. Glad you like it.

        I’m not aware of too many good finance blogs. A lot of them are guys trying to sell something. A few that I think are good include Calculated Risk: http://www.calculatedriskblog.com/
        Seeking Alpha: http://seekingalpha.com/
        Streetwise Professor: http://streetwiseprofessor.com/

        Streetwise is Craig Pirrong, a finance (energy mkts) prof at U Houston. That’s the only personal blog in finance that I check into regularly.

        So I think I understand your question re: cost of information. Basically we can think of it as a Coasian type transaction cost. Hard-to-get information is valuable and can (no guarantee) be used to generate abnormally high returns. Certainly we can see markets where materially relevant information is hard to get are actually pretty inefficient, like housing. People were able to generate high returns replicating a particular trading rule (e.g. flipping) for some time. Of course, inefficient markets can turn on a dime, just like efficient ones!

        Anything that impedes information being incorporated in the market, like rules against insider trading, or short sale restrictions, will reduce efficiency. Now, there may be other reasons to restrict insider trading and so forth, but making the induced inefficiency is a real cost.

      • marris says:

        Thanks for the links!

  6. Major_Freedom says:

    So if that’s right, then if we could find a period where hedge funds did very well–as in, they beat other sectors of the market–then that should be an argument against the EMH.


    The EMH isn’t explicit in the time periods when such words as “persistent” and “continuously” are used. One could always go before and after a period time of “beating the market” and say “Hey look everybody, this guy didn’t “persistently” beat the market. EMH is therefore true.”

    I think those who adhere to EMH are people whose minds tend to collapse to rigid stability concepts of final equilibrium and whatnot. That’s a big problem because the real world market takes place over time, and people’s ability and knowledge changes too. Individuals have used their ability and knowledge to beat the market for periods of time. Sure, they can’t keep doing that once their ability and knowledge becomes generalized, but by that time, there will already be new individuals with new abilities and new knowledge.

    EMH is constantly “violated.”

  7. Beefcake the Mighty says:

    “the EMH is a tautology, it’s a way of viewing the world. ”

    Is it supposed to follow that if something is a way of viewing the world, then it’s a tautology? Because, it’s anything but obvious to me, maybe Bob can elaborate.

  8. JP Koning says:

    ““the EMH is a tautology, it’s a way of viewing the world. ””

    Agreed. I see it as a banal sort of accounting identity. Assets = Liabilities + shareholder equity.

    It’s the behavioral analysis that gets these quantities to equilibrate that is interesting.

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