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When the Royal Swedish Academy of Sciences announced that Eugene Fama, often considered to be the father of the efficient market hypothesis (EMH), and Robert Shiller, a pioneer in behavioral finance and critic of EMH, would share the 2013 Nobel Prize in economic sciences (along with Lars Peter Hansen), it made clear that there was no settled doctrine when it comes to how asset prices are determined. Cliff Asness, a former student of Fama’s, has applauded the decision, recently telling delegates at the 67th CFA Institute Annual Conference that the Nobel committee got it right.
Although he has made a living by exploiting anomalies associated with such factors as value and momentum, Asness also believes that markets are efficient, if imperfectly so. He said, “I’ve learned to live with my schizophrenia. While I’m not a hard-core efficient marketer, I do think markets are closer to efficient than most practitioners do.” Asness’s presentation originated from an article he coauthored with AQR colleague John Liew for Institutional Investor titled “The Great Divide over Market Efficiency” and culminated with what he considers important implications for the asset management business going forward.
Noting the challenges of active investing, Asness declared market efficiency to be “the proper starting point” for most individual investors. But he didn’t advocate just owning index funds. Behavioral-based challenges to market efficiency, like value’s long-term dominance over growth, suggest that investors may benefit from deviating from the market. But, as English economist John Maynard Keynes once warned, “The market can stay irrational longer than you can stay solvent.” An investor’s tilt toward behavioralism should thus align with his tolerance for volatility in returns.
In a manifesto of sorts, Asness also addressed the proper role of central bankers and regulators when it comes to financial markets. The government, he said, should not be in the business of “catching and stopping bubbles.” Noting that Shiller was years early in his calls of bubbles in the technology and housing markets, Asness doubted that the government could forecast bubbles with a greater degree of accuracy than the private sector. And deflating perceived bubbles without overreacting and crimping growth is far from assured.
“Too big to fail,” Asness asserted, is the enemy of the efficient market; without downside risk, markets can become “hamstrung.” Similarly, he called on government not to subsidize or penalize some activities over others, as playing favorites frequently leads to unintended consequences. He also noted that activities such as short-selling add pricing discipline to markets and should be encouraged by the government. Such mechanisms allow stocks to reflect all information, add liquidity, and ultimately lower costs.
Asness closed with a nod to fans of both Fama and Shiller by noting that although the market isn’t perfect, it is the best allocator of capital over the long term. At the same time, he said the “perfect efficient market people are going a little too far when they say don’t worry, people will find it in the footnote. People don’t always find the footnote.”
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Photo credit: W. Scott Mitchell