What do you know that no-one else knows? If a share really is the wrong price, why haven’t other people spotted it and, by buying or selling, forced it to the right price?
These are the sort of questions that are the crux of the debate on ‘active’ or ‘passive’ investment management. While active managers believe they can outperform a benchmark after fees (risking underperformance by attempting to do so); adherents of passive investment management believe markets are ‘efficient’ and prefer very slight underperformance with certainty (passive vehicles still charge some, albeit smaller, fees).
No stone left unturned
So what does efficiency mean in this sense? The concept is that all relevant information regarding the outlook for an asset price has been processed by the innumerable investors around the world and incorporated into the price today. The price is the best estimate of fair value because investors are rational, or because it would otherwise be arbitraged away.
Securities’ prices will move as breaking ‘news’ affects the outlook for the company or people’s attitude to risk, but essentially that news will not be predictable on a systematic basis.
Forecasters or investors will be right some of the time, but also often wrong. Some will have lucky careers through no skill of their own, others particularly unlucky ones; and most will be wasting their time.
It is an appealing theory – and it must be taken seriously. After all, there are millions of investors around the world, highly intelligent, highly incentivised and with all the same sophisticated technology and information sources. Why would they leave the proverbial £10 note lying around on the pavement for you to pick up?
But, hang on, isn’t Ashburton Investments an active manager and isn’t successful active management dependent on the existence of ‘inefficiencies’ or opportunities? Absolutely. However, it is only by taking the theory of efficient markets seriously that we can start to think about reasons why it might not always hold and where the opportunities may lie.
Exposing the myth
The Efficient Markets Hypothesis (EMH) is a powerful concept, but there is by now considerable evidence which undermines it. Markets are not always efficient; assets are sometimes mispriced and therein lies the opportunity for active managers.
The failure of EMH relates to both psychological and institutional factors, the latter relating to market frictions. In terms of the former, the now-mainstream field of Behavioural Economics has shed considerable light on individual and group decision-making and behaviour, with research by the likes of Nobel Laureates Robert Shiller and Daniel Kahneman (and many others) exposing the myth of fully rational behaviour.
Even so, irrational behaviour might plausibly be arbitraged away by opportunistic investors. However, institutional constraints or market frictions frequently prevent it. Agency problems (intermediaries acting on behalf of the end investor), segmented markets (the participants vary from market to market) and liquidity issues are reasons why ‘mispricings’ (read opportunities) may persist. A third factor which might not strictly contradict EMH, but which would allow for the predictability of investment returns, is time-varying attitudes to risk.
In other words, people ‘rationally’ become more risk averse in bad times (recessions) which means prospective returns from buying risky assets are likely to be highest during such times. The Lehman shock of late-2008 is a classic example.
Taking a holistic approach
At Ashburton Investments, our mission is to generate superior risk-adjusted returns for our clients. We do not have access to information or technology that cannot be sourced by other professional investors. We must therefore rely on superior interpretation of that information and our understanding of market behaviour, which incorporates an appreciation of the circumstances when the EMH is likely to fail and market mispricings occur.
At a macro level, there is considerable academic evidence to suggest that risk premia vary over time and buying an asset when its implied risk premia is high (and valuations low, in other words) is likely to result in excess returns over the medium to long-term
(5-10 years).
There is evidence of this across a variety of markets: equities, bonds and foreign exchange, for example. At times, our tolerance for risk will therefore need to move in the opposite direction of wider market participants – be “fearful when others are greedy and greedy when others are fearful” to use Warren Buffett’s words.
We believe most participants in financial markets have extremely short time horizons. Over such time horizons, the performance of markets is largely random or unpredictable. However, we believe that superior analysis can pinpoint longer-run trends, which may be ignored by other market players focused only on the short-term. Investing in these medium-term strategies (eg 1-3 year horizons) can often be a profitable strategy over time.
Because we believe market segmentation exists, we take a holistic, global approach to investing across asset classes. Exploitable opportunities may not be present in all markets at all times so we look to concentrate efforts on areas where we believe mispricing is present. Our multi-asset team has considerable experience in investing across all asset classes in all regions, both in cash and derivative markets.
At a direct stock or bond level, it is clear that opportunities are much more likely to occur in areas which are less mainstream or away from the scrutiny of most analysts and investors. These may be in emerging markets, smaller companies or various niche areas, for example.
Within the bond market, the huge growth in passive ETF funds has created opportunities to buy similar bonds at higher yields simply because they are not included in the benchmark.
We also aim to incorporate ‘factor’ analysis into our thinking. For example, while many professional investors sneer at momentum strategies as a low-brow approach, there is considerable academic evidence to suggest momentum is prevalent in markets. Most likely this is because investors are slow to incorporate information and there is a positive feedback loop between price momentum and beliefs. Momentum, therefore, merits consideration.
The theory of efficient markets is powerful. It should not be easy to outperform the market. At the same time, there is plentiful evidence to indicate it often fails. We can look at some of the biggest bubbles in history that have occurred over the past 20 years as evidence, or the weight of academic research. A robust investment process therefore needs to take EMH on board and a better understanding of its failings is necessary to exploit the opportunities that come with them.
