Inefficient markets leave room for active management

By Dean DiSpalatro | September 11, 2013 | Last updated on September 11, 2013
5 min read

Are markets efficient? It’s a decades-old debate, and the pendulum has swung in favour of market efficiency’s opponents. This is good news for active managers, whose value propositions say they can identify and capitalize on mispriced securities.

We asked leading academics to walk us through Efficient Markets Theory (EMT) and its problems.

The random walk

Studies done in the 1950s and 1960s “documented seemingly random characteristics to common share price changes, reporting that stock price patterns may not be distinguishable from randomly generated patterns,” says Eric Kirzner, professor of finance at the University of Toronto’s Rotman School of Management.

He notes these notions eventually morphed into EMT, which has three forms:

  • Weak: analysis of past data is of no use for generating excess returns;
  • Semi-strong: superior returns can’t be achieved through analysis of publicly available financial statements and economic forecasts;
  • Strong: managers don’t have any edge when using specialized data.

Return on inefficiency

Markets tend to be inefficient in the short term, but settle down in the long term.

Can you really beat the market?

Evidence suggests markets are inefficient to varying degrees over time. This means it’s possible to earn excess returns through active management.

Yet proponents of passive investing point to the S&P Indices Versus Active Funds (SPIVA) Scorecard.

For instance, the U.S. Year-End 2012 report says, “performance lagged behind the benchmark indices for 63.25% of large-cap funds, 80.45% of mid-cap funds and 66.5% of small-cap funds.”

The 2011 year-end report claims “the only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.”

Another metric paints a different picture. Martijn Cremers of the University of Notre Dame and Yale’s Antti Petajisto say the concept of active share is the best way to settle the active/passive debate. It measures how much a fund deviates from its benchmark.

The academics found the more different a fund is from its benchmark, the more it outperforms the benchmark after fees. Funds that are more similar to the benchmark tend to underperform.

Their work suggests one reason some active managers underperform is that many of their funds deviate little from the benchmark.

Ming Dong, associate professor of finance at York University’s Schulich School of Business, says, “We know during the tech bubble prices were inflated and during the crisis of 2008 they were well below true value.”

Even when prices are pretty close to true value, there’s still variation across stocks. At any given point there’s misevaluation—and therefore inefficiency—somewhere in the market, Dong explains.

Managers looking for inefficiencies should focus on stocks with low P/E ratios. “There’s enough evidence to show they tend to outperform,” says Western University’s George Athanassakos, adding this is especially true of smaller companies analysts don’t follow too closely.

“Many of the big institutions and high-calibre investors aren’t interested in these smaller stocks,” he explains. “They have a lot of money to invest and these companies don’t have enough depth to accommodate their buying power. So these stocks tend to be neglected, resulting in undervaluation.”

Kirzner notes one study, spanning returns over nearly 60 years, found small stocks outperformed the S&P 500 Index by about 5.79% per annum.

Some managers can make money on higher P/E stocks, but that’s difficult because they’re on everyone’s radar.

“Take General Electric, Johnson & Johnson and other stocks that trade several million shares. Typically the price will reflect all publicly available information,” says Athanassakos.

Kirzner was a strong supporter of EMT until fairly recently—evidence of inefficiency turned him into a proponent of value investing. He notes the typical mutual fund doesn’t outperform the index. If you’re going to beat the market, you need to look for opportunities “in highly specialized areas—you probably won’t find them in U.S. large caps,” he says.

Anomalies rule

Opponents of EMT cite some well-established anomalies:

  • Neglected-Stock Effect: stocks that aren’t popular among big investors, or neglected by investors in general, pull in higher-than-expected returns;
  • End-of-the-Year Effect: securities prices typically fall in December, and rise in January;
  • Day-of-the-Week Effect: prices tend to be lowest on Mondays, and highest on Fridays.

Kirzner notes about 45 such anomalies have surfaced, “providing grist for the view that superior investment analysis and investigation can yield positive returns.” He also cites recent research that shows momentum-based strategies are effective.

“This is inconsistent with market efficiency. The strategy involves building a portfolio of top-performing stocks over the past year or so. You’d think the winners in one period would be losers in the next. These studies show otherwise.”

New-generation indices

Compiled by Lisa MacColl

All information current as of July 2013.

1. Fundamental weighted

Indices created using alternative rules-based strategies. rather than strict market cap weighting, have been gaining popularity.

The First Trust Canada AlphaDex (FCAN) fund is a fundamental index launched in 2013. It has almost $20 million in AUM.

The iShares Canadian Fundamental Index Fund (CRQ) comprises companies selected on the basis of three factors aggregated over five years: total cash dividends, free cash flow and total sales. Current book value is also taken into account. The fund currently has more than $210 million in AUM.

2. Laddered

Providers have created indexed ETFs constructed like laddered portfolios: with buckets of securities that each matures on a different date.

The BMO S&P/TSX Laddered Preferred Share Index ETF (ZPR) follows this strategy. The Index includes Canadian rate reset preferred shares that meet size, liquidity, listing and quality criteria. The Index uses a five-year laddered structure where annual buckets are equal-weighted, while constituent securities within each bucket are market-capitalization weighted. Started in November 2012, it has $832.2 million in AUM.

3. Sector specific

Sector-specific indices such as U.S. healthcare and U.S. technology are accessible to Canadian retail investors through index ETFs. For example, the iShares S&P Global Health Care Index Fund (XHC) has holdings in the US healthcare field such as Pfizer, Merck & Co and Gilead Sciences Inc. AUM is almost $49 million as of July 2013.

The BMO China Equity Index ETF (ZCH) follows the BNY Mellon China Select ADR Index fund. It gains exposure to the broad Chinese equity market by holding a basket of American Depository Receipts traded on the New York Stock Exchange (NYSE), NYSE Amex or NASDAQ, which are domiciled in China. AUM is $10 million.

4. Preferred share

Preferred shares can be difficult for retail advisors and investors to get information about, so this type of ETF provides lower-cost access.

5. Unhedged currency

Unhedged currency products give the underlying index return with a full currency effect. For example, if the return goes up 5% in the day, but the currency goes down 4%, an investor is only up 1%. This is suitable for investors bullish on foreign currencies.

Dean DiSpalatro