Stock Market Efficiency: Micro or Macro?
One of the great debates in finance is whether stock markets are efficient or inefficient. In 1998, Nobel Prize-winning economist Paul A. Samuelson argued that the efficient market hypothesis (EMH) should work better for individual stocks (meaning that the markets are micro-efficient) than for the stock market as a whole (in which case the markets would be macro-efficient).
He made the case that in today’s markets, the minority of investors who spot aberrations from the micro-efficiency perspective can make money from those occurrences and, in doing so, they tend to wipe out any persistent inefficiencies. Samuelson also noted that, in no contradiction to the previous sentence, he had hypothesized considerable macro-inefficiency, in the sense that long waves in the time series of aggregate indices of security prices exist above and below the various definitions of fundamental values.
Given it wasn’t all that long ago when the bubble in growth stocks burst (March 2000), it’s hard to argue against the concept that markets can be macro-inefficient. At the time, the earnings yield of the ShillerCAPE 10 ratio (a common valuation metric) was near 2 percent and the yield on riskless, long-term Treasury Inflation-Protected Securities (TIPS) was close to 4 percent. The expected real return on riskless TIPS was, thus, about twice that of the expected real return on risky stocks. One could say that’s the very definition of a ‘bubble’.
There’s an overwhelming body of evidence that Samuelson is correct about the market being micro-efficient. The latest academic research finds that even before considering taxes, only about 2 percent of active, stock-picking mutual funds are able to generate statistically significant, risk-adjusted alphas sufficient to cover their expenses. But what about macro-efficiency?
For investors, however, the real question should be whether there are market actors who can persistently exploit any macro-inefficiencies sufficiently enough that they are able to reliably generate alpha after accounting for the expenses of the effort. As one practical test of that ability, we can look to the performance of the global HFRI Macro (Total) Index.
The HFRI Indices are broadly constructed and designed to capture the breadth of hedge fund performance trends across all strategies and regions. For the latest five-year period, ending July 2016, the HFRI Macro (Total) Index returned just 0.75 percent per year. Let’s compare that to the returns of various equity indices over the same period. The S&P 500 returned 13.4 percent per year, the MSCI EAFE Index returned 3.0 percent per year and the MSCI Emerging Markets Index returned -2.8 percent per year. An equity allocation matching global market capitalization would have about 50 percent in U.S. stocks and the remainder split in about a 3:1 ratio between non-U.S. developed markets and emerging markets. Thus, a simple market-cap-weighted, non-rebalanced portfolio would have returned about 7.5 percent, outperforming the ‘masters of the universe’ by almost 7 percentage points per year. With annual rebalancing, the return of the global market portfolio would have improved slightly to 7.6 percent.
Now, to be fair, these are the returns of indices, which do not have expenses. However, using Vanguard mutual funds, you could build such a portfolio for around 0.1 percent. I would also note that the macro advisors underperformed even the five-year U.S. Treasury note, which returned 2.1 percent over the same period, and barely outperformed the virtually riskless one-year Treasury bill, which returned 0.3 percent. Virtually any balanced portfolio would have outperformed the macro advisors.
We can also see evidence regarding the ability of active mutual fund managers to exploit macro-inefficiencies by looking at the performance of tactical asset allocation (TAA) funds.
Morningstar has done a series of studies on these funds, which have the objective of providing better-than-benchmark returns with (possibly) lower volatility. This, theoretically, is accomplished by forecasting returns of two or more asset classes and varying the allocations accordingly. A TAA fund would then be measured against the appropriate benchmark.
While the benchmark might be 60 percent S&P 500 and 40 percent Barclays Bond Index, the manager may be allowed to have his or her allocations range from 50 percent to 5 percent for equities, 20 percent to 50 percent for bonds and 0 percent to 45 percent for cash. In reality, TAA is just a fancy name for market timing. Morningstar’s research has consistently found that TAA funds underperformed their benchmarks, and did so by margins well in excess of their fees.
The Bottom Line
While someone could certainly make the case that markets may not be highly efficient in a macro sense, there still doesn’t seem to be evidence that there are so-called ‘masters of the universe’ who can exploit such macro-inefficiencies. The evidence against such ability is likely what led Warren Buffett to conclude: “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”
This commentary originally appeared September 7 on MutualFunds.com
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