A month ago, The Globe and Mail published an article called "Can’t beat the market? There’s a theory for that", promoting the Efficient Market Hypothesis (EMH), which says that "active investment managers are not worth the cost." I disagree.
EMH was almost conventional wisdom when I was studying finance in the 1980s. But belief in it has been shaken by the market’s inability to foresee macroeconomic shocks and disruptions such as the Asian financial crisis of the late 1990s and the catastrophic global financial crisis of 2008.
EMH hinges on the concept that "arbitrage" profits – that is, profits gained from taking advantage of price differences across markets -- are rapidly eliminated by active managers buying and selling the slightly mispriced assets. This trading activity ensures that in an open and liquid market, the price of any financial asset quickly incorporates all known information – making it difficult for most investment managers to add enough value to pay for their costs. That’s the theory.
But markets are not always open and liquid, and volatile markets have uncovered two major practical problems with EMH.
First, disruptions in the financing markets tend to cause transaction costs to rise, which dramatically reduces the ability to find arbitrage opportunities. Second, the amount of money available to arbitrage these opportunities is now radically reduced because banks have had to reduce their balance sheets. Consequently, some relative value investors have seen apparently undervalued assets go down in price anyway, as poor financial conditions prevent the ability to arbitrage.
As more economists recognize the flaws in the EMH, academic research efforts have turned toward the growing field of behavioural finance: the study of (often inefficient) human behaviour in financial markets. This discipline tries to explain observable behaviour, such as investors’ habit of taking profits too early while waiting too long to cut their losses. Behavioural finance research informs the study of active management, and it can shed light on why some investors are consistently successful while others are not.
Another academic framework that can help explain the inherent benefits of active management is the Capital Asset Pricing Model. In short, CAPM theory says that over time, investing in assets with higher risk should be rewarded with a rate of return above the "risk-free" government bond rate.
Active portfolio management can be viewed through a similar framework. The market indexes that portfolios are measured against can be used as the initial measurement in place of the CAPM risk-free rate of turn. In other words, one could purchase an index fund, taking no additional market risk, and receive this benchmark return. Active managers deliberately take additional market risk and deviate from the index with the objective of outperforming the benchmark index while managing the risks – taking risk only when the potential rewards look attractive.
In this framework, active managers attempt to outperform their benchmarks by systematically and appropriately taking market risk, in the same way that the CAPM would anticipate that over the long run, returns on stocks should exceed the risk-free rate. Of course, it’s also possible for active managers to underperform the benchmark index, just as the stock market can underperform relative to government bonds or money market securities (particularly over shorter time periods).
Investors should seek managers with sustainable comparative advantages that systematically help them to identify and capitalize on market inefficiencies.
There are two main ways to assess a manager’s ability to outperform a market benchmark:
1. Is there any structural reason (i.e., explainable by behavioural finance) the benchmark is flawed?
2. Does the manager’s investment process enable it to construct and manage portfolios that are best positioned to consistently outperform the benchmark?
Selecting the market benchmark is very important, and some benchmarks are flawed. For instance, Italy is the third-largest bond market in the world but far below third-best in limiting credit risk. Yet in some global bond indexes, Italy would still be the third-largest exposure. And Canadian bond indexes endure a structurally poor corporate bond market, where many passive investors have overpaid for the debt of a small number of sophisticated issuers.
To expand on the second point above, several key factors can help investors evaluate an investment manager’s ability to construct portfolios that are best positioned to consistently outperform the benchmark:
1. Is there a track record of outperformance through the business cycle?
2. Does the manager have a consistent investment process that is adaptable to various market conditions?
3. Does the manager have a robust risk management process that also takes into account time varying risk premiums in the markets?
4. Does the manager have access to high-level industry and thought leaders?
5. Does the manager have the resources to conduct high-quality proprietary research?
6. Does the manager have access to securities in the markets (both primary and secondary) that are likely to consistently outperform the benchmark?
This last point is crucial. It goes to the heart of what Richard Grinold called in 1989 "the Fundamental Law of Active Management," which says that superior performance is a function of manager skill and the breadth of the opportunity set. I believe that active management that searches the world for a diversified set of investments enhances a manager’s opportunity to consistently beat market benchmarks.
Looking ahead to a secular period when consumers, banks and governments will need to cut their leverage after their decade-long debt binge, we expect volatile and disrupted markets – far from efficient. Investors should seek active managers who have time-tested investment processes and risk management capabilities, and who are able to identify structural inefficiencies in markets. A comprehensive, active approach to portfolio management can be well-suited to capitalize on this market volatility.
Ed Devlin is an executive vice president and head of Canadian portfolio management for Pacific Investment Management Company LLC (PIMCO).
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