Make Inefficient Markets Work For You
By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report
One of the single biggest fallacies foisted upon the investing public is the notion of an “efficient market.”
Academics love it, which is why the “efficient-market hypothesis,” or EMH, as it’s known, is taught at all the leading B-schools. The broadest version of this theory holds that securities prices already reflect all known information; EMH proponents believe it’s impossible to outperform the markets over time – except by luck.
The reality, however, is that the markets are anything but efficient. In fact, not only are the markets highly inefficient, but – as many investors have learned the hard way – they are frequently completely irrational, as well.
First published in 1965 in The Financial Analysts Journal, the efficient-market hypothesis was the result of a nonsensical doctoral thesis penned by Eugene Fama. He hypothesized that the markets are characterized by multiple participants acting in a rational manner in an effort to profit. Fama believed – as the majority of EMH proponents do – that in an efficient market, competition among the participants leads to a situation where the actual prices of individual securities (stocks, bonds, exchange-traded funds, and the like) already reflect the combined total of all known information.
The bottom line: Stock prices, therefore, reflect reasonable intrinsic values at all times. [One version of the efficient-market hypothesis, the so-called "strong" version, actually holds that securities prices reflect all information - even information known only to company insiders, and to no one else out in the marketplace].
Few people understand that the belief in market efficiency – as much as any other factor – is one of the single-biggest justifications for all sorts of things that we take for granted today, including:
- Mark-to-market accounting systems.
- The concept of total returns.
- Efficient frontiers.
- And even various stock-rating systems.
Market efficiency even provides the underpinning for the so-called “prudent man” rules that are so critical to ERISA (Employee Retirement Income Securities Act of 1974) funds and the entire money-management industry, not to mention much of the Financial Accounting Standards Board (FASB) regulations.
Well, at the potential of really igniting an e-mail bonfire, we need to ask ourselves: If the markets are truly this efficient, why do all the research? Why would we have an entire industry of analysts who are collectively paid billions of dollars a year to ferret out information that the efficient-market hypothesis says is already reflected in current market prices? In fact, why would we even have the concept of “insider trading” to deal with or be so concerned by American International Group Inc. (AIG) type bonuses or even the Federal Bailouts if things were truly “known?”
The inconvenient truth is that the markets are wildly inefficient and they can be so for much longer periods of time than people realize – or that “experts” would admit.
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Moreover, as my own research shows, the markets are neither one-dimensional nor three-dimensional, and they are also not characterized by “log-normal distributions.” They are, in fact, fractal creatures that can shift from trending to non-trending in an instant. And they are increasingly characterized by something called “fat tails.”
When you hear that last term – and you will with increasing frequency in the years ahead – it will be most associated with huge market moves that had previously been unthinkable, or regarded as impossible. Nassim Nicholas Taleb does a great job of describing them as “Black Swans” in his book by the same name.
For most people, this will be a discussion best accompanied by a stiff drink – so you can skip the next few paragraphs if you like. The important thing to understand – and to come to terms with right now – is that the “impossible” happens a lot more than its label implies.
In recent years, people have become entirely too comfortable with the notion of “normal” markets and that’s one reason why so many investors are hurting so badly now. They came into 1999, and into 2007, with portfolios that were too heavily weighted in stocks and other holdings that relied on “normal” market behavior and historical precedent. Those investors sealed their own fates by believing that the fancy diversification graphs they got from Wall Street investment houses would protect them; instead, they discovered that diversification doesn’t work when everything goes down together.
It’s one of Wall Street’s dirtiest secrets and has emerged as one of the most hotly debated topics in Washington today.
Research (mine and that of others who are a lot smarter than I am) suggests that conventional diversification theory based on lognormal market distribution actually camouflages risk, instead of reducing it. That’s why companies such as AIG, Lehman Brothers Holdings Inc. (LEHMQ), and others, got into so much trouble. By placing their trust in errant models, the quants that were supposed to be protecting the hen house let in the foxes without ever realizing what they had done.
The experts’ mathematical models were supposed to account for “normal” conditions. Nobody asked what would happen when the improbable black swan showed up. And if they did ask, they sure as heck didn’t pay attention to the answers, because it may have ruined their plans for multi-gazillion-dollar bonuses. I can’t tell you how often in recent months I’ve heard insiders protest with comments and observations that “the markets aren’t supposed to do that.”
This is really neither here nor there though. For every day investors, the critical part to understand is that the markets are demonstrating behavior that’s supposed to be impossible on a much more regular basis than people realize.
Take, for example, a November study from Cook Pine Capital LLC. Like my own research, the Cook Pine study shows that in the last 81 years of Standard & Poor’s 500 Index data, so-called “three sigma” (or three-standard) deviations happened more than 100 times. Conventional log-normal modeling of the type AIG and others used heading into this crisis suggested that such events should have occurred only 27 times.
Oops.
And that’s not even as bad as it gets.
The Cook Pine study also demonstrated that the likelihood of a four-standard-deviation move on any given day is one in 100. Yet we’ve seen 43 of them since 1927. And even a five-standard-deviation move, which is theoretically impossible from a statistical standpoint, has happened 40 times in the last 81 years, including eight times since September alone.
This is precisely why I frequently point out to investors that while using conventional diversification is better than nothing, it’s often akin to rearranging the deck chairs on the RMS Titanic.
You’re much better off just getting off the boat altogether.
The rules of money have changed and this kind of data suggests that it’s how you concentrate your wealth that matters, particularly when it comes to avoiding the improbable – and even profiting from it.
One of the simplest ways to do this is through the use of non-correlated investments that zig when everything else zags. In the old days, that meant having exotic futures accounts or taking positions opposite to the markets entirely using margin accounts to sell individual stocks short – one stock at a time.
Unless you had a fair chunk of change to put into a managed account, chances were that you couldn’t effectively mitigate the risk of the unknown. Of course, traditional Wall Street brokerages dismissed futures for a long time, so that didn’t help. But that’s another story for another day.
What matters now is that there’s an entirely new class of “inverse” investments available to individual investors. Unlike managed-futures accounts, there are no account minimums and no active management fees. Most are available through online discount brokers and can be purchased just like stocks.
I’ve talked about these for years and I am absolutely amazed that more investors don’t use them.
Actually, I’m astounded.
Inverse funds, as their name implies, go up in value when the markets go down. There are plenty of choices to consider, with everything from the S&P 500 to specific sectors available in the mix. There are even double and triple inverse funds out there, which use swaps, futures and options in a fashion that allows them to move two or three times as much as the investment vehicles to which they are linked.
Of course, if the markets go up, the reverse is true and these things can lose money in a real hurry, so one can’t just pile in indiscriminately.
My research and that from groups like the CME Group Inc. (CME) and Chicago Board Options Exchange (CBOE) suggests that an allocation equal to 1% to 5% of your overall assets is about right when it comes to enhancing overall returns and lowering portfolio risk. Aggressive investors who take on as much as 20% in non-correlated assets can dramatically lower their “drawdown” in a bad market (from 41% for a stocks-only portfolio to only 7.5% for a diversified portfolio), while increasing their overall returns (from 7.4% for that stocks-only portfolio to 8.9% for the diversified portfolio). This holds even though they used parametric distributions to plan such things.
These are important lessons to take away from these troubled times. If you embrace such a strategy, chances are that you’ll not only be smiling on down days in the market but you’ll also come to actually enjoy the unpredictable markets we now live in, too.
[Editor's Note: As Money Morning Investment Director Keith Fitz-Gerald demonstrated in this essay, the ongoing financial crisis has changed the investing game forever, making uncertainty the norm and creating a whole set of new rules that will quickly determine who wins and who loses in today's global investing markets. Fitz-Gerald has already isolated these new rules and has unlocked the key to what he refers to as "The Golden Age of Wealth Creation." His key discovery: Despite the gloom, investors may well be facing the greatest profit opportunity of their lifetimes.
In his newly launched Geiger Index investing service, developed after more than a decade of work, Fitz-Gerald has amassed a winning streak of profitable picks. Check out our latest insights on these new rules, this new market environment, and this new service, the Geiger Index.]
News and Related Story Links:
- Wikipedia:
Efficient-Market Hypothesis. - Wikipedia:
Efficient Frontiers. - Erisa Glossary:
Prudent Man. - Wikipedia:
Nassim Nicholas Taleb.
- Wikipedia:
The Black Swan. - Wikipedia:
68-95-99.7 Rule. - RMS Titanic:
Web Site.
Comment by Anne Keller on 7 April 2009:
Two interesting things. One, you point out that markets can’t be analyzed, then say the “Geiger Index” can show the way when no other method works. Two, the inverse funds you mention do behave roughly like they’re supposed to for a day or so, but the longer you hold them, the less likely they are to continue to do what they say they will. Be very careful in recommending these as a buy and hold.
Comment by William Patalon III on 7 April 2009:
Dear Anne:
Thanks very much for taking the time to comment on Mr. Fitz-Gerald’s article this morning. We really appreciate readers taking the time to do so.
Let me take a moment to respond. The point that Mr. Fitz-Gerald was making — and that I want to make sure you understand — was that he believes the markets can be analyzed, but that the EMH is the wrong tool for doing so.
In fact, he’s a widely recognized pioneer in the use of “fractal theory” to analyze the constantly changing market structure and that’s what the Geiger is based on.
Let me also pass along a comment that Keith made about your commentary. He specifically asked me to compliment you on your observation on the tracking error associated with inverse funds. Not one in 1,000 investors he speaks with around the world understands that subtlety which is why he does not, in fact, recommend them as “buy-and-hold” investments. Nice call.
One of the real pleasures of this job is that we know that we’re writing for a high-level audience. Your note just underscored that point. Please feel free to drop us a note again.
Respectfully yours;
William Patalon III
Executive Editor
Comment by Mike O'Connor on 8 April 2009:
Fat-tail awareness started in roughly 1980, at about the time that the listed options market started up in earnest— after the Black-Scholes theory of options prices was published.
I have a book on options that is about 20 years old and it contains statistical data on the fat-tails stuff. So Taleb is not the first observer of the phenomenon.
Secondly, fat tails have nothing at all to do with whether or not past is prologue in the markets. You can have a distribution that is the result of utterly random processes that has a fat tail. (And “randomness” is very close to “efficiency”, as a practical matter, in that with it one can’t benefit from any market knowledge.)
Finally, the log-normal distribution is popular in part because it is stable, in the sense that it can easily be shown that successively applying a short-term log-normal distribution many times generates a long-term distribution that is also log-normal.
But a Mr. Levy showed, many years ago, that other distributions (fat-tailed among them) have the same desirable property (and that kind of stability is indeed a property that has a sort of “fractal” meaning to it). All of the Levy distributions are associated with pure randomness, which is to say that they are compatible with the efficient markets idea (though they are not directly based on it).
Comment by Mike O'Connor on 8 April 2009:
I should also join with Anne Keller regarding the perils of putting long-term money in ETFs that are short some class of securities.
Particularly when they funds are double-short, or “ultra” short as they say, it can easily happen that over the long term they go DOWN when the underlying stocks go down (rather than up when the underlying stocks go down).
That doesn’t happen on a day-to-day basis, just cumulatively. For example, take a look at URE and its inverse SRS. Both are down over the last 12 months.
Comment by jim gentile on 8 April 2009:
I have been trading the Rydex single, 1 1/2 and doubled leveraged funds since 1993, over 15 years and the comment above by Anne Keller is correct. The longer you hold them the worse they perform. A good example is the SKF, pro shares ultra short Financials. With financials down for the last year the fund is barely even. The volitility is very high and if you are on the wrong side of the trade you can lose 50% in a week. Trading these funds is very tricky and not unlike gambling in a casino. recommending them to the average investor, even with a disclaimer, is irresponsible and this comes from someone who recieved a degree in Financial Planning in 1990.
Comment by RC Fraser on 13 April 2009:
I have done a fair bit of number crunching and modeling of leveraged ETFs, as a result of having been an early investor in the Pro Funds leveraged OTC funds, having been right on my market call, and still lost money. (In other words, I invested in a leveraged bull fund, the market went up, and I LOST money!!!). I called Pro Funds and had several conversations with their reps and supervisors, but no one could explain how this was possible; they all kept mindlessly repeating that the fund was designed to track DAILY price movements, not longer term ones, but again, the question was, WHY would short term price movements not correlate closely with longer term price movements? Having gotten no help from the sellers of these products, I set out to figure it out myself.
Here is what I have concluded:
(1) The answer to the lack of correlation is that the link between short and long term performance of these funds is a PATH DEPENDENT PROCESS. That is, the correlation (or lack thereof) depends on the precise pattern of daily returns. Sometimes the correlations are close, so an investor gets returns that track relatively well with his/her “intuitive” guess that a 2 times leveraged bullish fund would return about twice the market’s return. Sometimes–often–the correlations are not close, and even perverse (the OPPOSITE of the “intuitive” expectation), like my experience.
(2) The particular characteristics of path dependency that resulted in the greatest amount and number of counterintuitive results was NUMBER AND FREQUENCY OF ADVERSE EXTREME DAILY MOVEMENTS. That is, for a BULLISH leveraged fund, the more big down days (adverse daily market movements), the worse the performance relative to expectation.
(3) One possible explanation for these perverse results is that the funds are not dynamically adjusted intraday for market exposure. To understand this adverse effect, consider a hypothetical extreme daily market movement of -25% for a 2 times leveraged bullish fund. At the end of the day, such a fund would be down 50%. At or after the market close, its holdings are readjusted to return it to a double leveraged position ON AN ASSET BASE THAT IS 1/2 what it was the day before. Suppose further the following day the market recovers, in percentage terms, and is therefore up 25%, so the fund is up 50%. Where is the investor now? He’s still down 25%. Where is the unleveraged investor, by comparison? She’s down only 6.25% (1 times .75 times 1.25). The hapless leveraged investor, then is down 4 TIMES what the unleveraged investor is down, rather than down 12.5%, his intuitive expectation of DOUBLE the underlying market movement. The leverage investor gets clobbered because the market recovery IN PERCENTAGE TERMS (25% down and then 25% up) is NOT a market recovery for the investor. His recovery took place on position that was down by 50% from its starting point. So, IN DOLLAR TERMS, he gets back only half the number of dollars he lost.
(4) To summarize, bad news (big adverse daily market moves)is REALLY bad news for the leveraged fund shareholder, considerable worse than his intuitive expecation. Throw in a considerable number of extreme adverse daily market moves during a given holding period, and the result can become devastating.
(5) The reverse is also true, that is, under the right conditions (an extreme number of large POSITIVE daily price movements), a leveraged fund can outperform the intuitive expectation.
(6) All of these funds by Pro Funds and Direxion fund groups are burdened with high expense ratios, reducing the investor’ s returns under any market return scenario.
(7) As a result of my own experience and my analysis of hypothetical returns under simulated market conditions, I would advise anyone to be extremely cautious about trafficking in any of these leveraged funds. Unless you are very good or lucky about predicting short term market movements, the likelihood you will lose money is high. The longer you do it, the more likely it is you will lose money.
(8) The creation and promotion of these products is yet another indictment of EVERYONE is the so-called financial services businesses. The sell-side (brokerage and investment banking) and buy-sides (investment management, including mutual funds) of the business are both set up to TAKE investors’ money, not to MAKE investors money. An investor is well advised to be suspicious of EVERYONE who has something to sell him–broker, investment banker, newsletter writer, managed futures and CTA’s hedge funds, etc. NO EXCEPTIONS.
(9) With all due respect, I believe Mr. Fitzgerald’s praise of these funds is misguided. THEY ARE EXCEPTIONALLY DANGEROUS. I WILL BET ANYONE MONEY THAT THE OVERWHELMING NUMBER OF INVESTORS WHO COMMIT MONEY TO THEM WILL LOSE.
(10) I don’t have time to point out all the errors in Mr. Fitzgerald’s ridicule of the EMH hypothesis, but from my study the evidence is OVERWHELMING that markets are generally efficient most of the time. That is, quite simply, why it is so difficult for anyone to beat the market over time on a risk-adjusted basis. Mr. Fitzgerald: if markets are so inefficient, I would assume you personally have made lots of money by taking advantage of these inefficiencies with your own money, right? How about proving your thesis by showing your readers the money you have made? SHOW US THE MONEY!!
Why don’t you run a mutual fund or a hedge fund if you have such exceptional talent and ability? In 30 years’ experience I have NEVER SEEN MUCH EVIDENCE THAT ANYONE CAN CONSISTENTLY BEAT THE MARKET ON A RISK-ADJUSTED BASIS. Of course it’s a big world out there, and there may be a small number of exceptions to this rule, but even if there are, they are few and far between. (By the way, I have an MBA in finance, and have considerable professional experience on both the sell and buy sides of the market, including being a former partner in a multi-billion dollar registered investment advisory firm.)
Comment by sam on 16 April 2009:
very, very interesting article. i was arguing this point with friends at http://www.affluence.org – and while theyve done well in the market, they believed in an efficient market, i could not convince them otherwise. ill send them this and maybe change their mind.
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