Tag Archives: Efficient Markets Hypothesis

What Your Advisor Believes (And Why You Should Question It)

Chances are your financial advisor believes in two related intellectual theories that you should question them about.

In a recent article, the excellent columnist Brett Arends wrote about the two theories governing most financial advisors – the efficient markets hypothesis (EMH) and the capital asset pricing model (CAPM). These sound like impossibly complicated things, but they’re not. The first theory says prices are right, or nearly right all the time, and that it’s, therefore, basically impossible to beat markets. The second theory says historical asset class returns will repeat and that the more risk you take (with risk meaning volatility), the more return you will make. So, for example, stocks are very volatile, but they’ll produce the best returns — something like 10% annualized (or 6.5%-7% after inflation) – over longer periods of time.

Theoretical Problems

But the theories aren’t always right. For example, if stock prices reflect all available information, why are they so volatile, as Arends asks? It may be because that information is always incomplete, and as more information emerges prices change accordingly — and correctly. But extreme volatility may also exist because people are irrational or emotional, and substitute stories or “narratives” for more rigorous analysis or even basic common sense. The rise of the tech bubble, for instance, wasn’t an example of new information being priced in as much as it was an instance of people’s imaginations getting the better of them, andcausing them to inflate the prices of stocks that had no underlying earnings or even revenues.

More problems: why have U.S. stocks (the S&P 500 including dividends) produced a less than 6% nominal return from 2000 through November 2018? Why did they deliver nothing but dividends from the mid-1960s through the early 1980s? And if stocks are such inflation-beaters, why did the S&P 500, including dividends, return only 65 annualized in the 1970s, far underperforming that decade’s inflation?

Future Returns

The facts of the matter are that prices aren’t efficient and asset class returns may not repeat for the, say, 25-year period your retirement plan is counting on them to do so. Bonds returns, for example are easy to forecast. They generally follow the yield-to-maturity. That means a portfolio of 8-year or so domestic investment grade bonds, such as one finds in a fund tracking the Bloomberg Barclay’s US Aggregate Index, now will almost certainly deliver around 3.3%.

And for the S&P 500 Index to return 10% over the next decade, it must trade at a higher P/E ratio than it does now in addition to delivering around a 2% annual dividend payment and 4%-5% earnings-per-share growth. That’s possible, but unlikely, because U.S. stocks are trading at around 30 times their past 10-years’ worth of earnings. They’ve only been that expensive in their runs in 1929 and 2000. Although nobody can be certain, it’s more likely that P/E ratios will decline over the next decade, not increase, cutting into the 6%-7% nominal return from dividends and earnings-per-share growth. Adherents of CAPM, don’t view the world this way, and think prices can keep rising so that it’s almost a long-term investor’s birthright to achieve 10% annualized returns.

If your broker or advisor can’t respond to these objections that their assumed future returns might be off – by a lot – there’s a good possibility that they’re too dogmatic, and have swallowed academic finance without digesting it or thinking about it.

What this means for your portfolio

The problems in these theories mean your portfolio may not be set up to satisfy your financial plan. As Arends mentions in another article, for the decade from 1938 to 1948 a balanced portfolio went backwards relative to inflation. It did the same disappointing thing from 1968 through 1983. With the Federal Reserve taking us into uncharted waters and returns prospects for major asset classes so low, investors should look at cash, real estate, foreign stocks, and commodities, including gold.

None of these by themselves is foolproof. Some of them have performed well in some instances when stocks and bonds have faltered, and others have performed well at other times when stocks and bonds have faltered. The most important thing is that an advisor sensitive to how warped the current market and situation are right now may be your best defense against tepid stock and bond returns. Making sure your advisor hasn’t fallen hook, line, and sinker for the Efficient Market Hypothesis and the Capital Asset Pricing Model may be the best way for you to navigate the next decade or so in the markets.

The Problem With Indexing

Indexing your investments is a good way to increase your chances of doing better than average. Most active investors trying to pick winning stocks (and avoid losing ones) don’t beat the index. Those who do are hard to identify ahead of time. Once you think you’ve identified a market-beating manager, they often allow their fund to get too big, which typically reduces their chances of repeating their past success. And sometimes they’re on the cusp of retirement. Or they’ve lost analysts who’ve helped them be great. In other instances, you might be correct in thinking they can outperform over the long term, but you’re about to capture one of their fallow periods. Nobody ever said this game was easy.

Yet, there are problems with indexing too. “Indexing” generally means following what’s called a “capitalization weighted” index. That means the rank of the stock in the index is determined by how much the stock market values it. Market capitalization is the total shares of a stock outstanding multiplied by the price per share. But is taking the stock market’s verdict about where a stock should be ranked in an index reasonable? Many people think it isn’t. After all, you necessarily own more shares of the most favored and possibly expensive stocks in a capitalization weighted index.

When the first index fund – the Vanguard 500 Index Fund – came to the market in the early 1970s, academic finance was dominated by the notion that the market prices stocks properly – or accurately, based on available information – at all times. That made it seem reasonable to rank stocks by how the stock market says they should be ranked.

But there’s a case to be made that ranking stocks based on their underlying companies’ economic fundamentals such as sales, earnings, dividends, and book value might also be reasonable. And if stock markets don’t always set prices properly, if they are sometimes the victims of emotion gripping their participants, maybe focusing on economic fundamentals of the businesses is a smarter approach to indexing. And, after all, if you rank stocks based on companies’ underlying economic fundamentals, you’re arguably not showing any disrespect for markets. You might just be elevating the markets for companies’ goods and services over the market that trades those companies’ stocks.

An easy way to “break the link” (as Rob Arnott, founder of fundamental indexing, puts it in describing all “smart beta” strategies) between market capitalization and index rank of a sock is to start with a capitalization weighted index, but then rearrange it in a way that equally weights the stocks. No attention to underlying economic fundamentals needed.

This is the subject of a new paper published by Standard and Poor’s. First, the paper documents the outperformance of equal-weight indexes compared to their capitalization weighted equivalents. According to the paper the S&P 500 Equal Weighted Index has outperformed the S&P 500 Index by 2.1 percentage points. Moreover, this outperformance or “alpha” exists in international markets as well.

How much money is 2 percentage points annualized? It can amount to $50,000 in a scenario that’s not difficult to imagine for an ordinary investor. For example, if you invest $5,000 for 25 years and earn 5% annually on the investment, you’ll wind up with just under $340,000. If you invest the same amount for the same time frame, but earn 7% annualized instead of 5% annualized, you’ll wind up with just under $390,000.

The most obvious reason for the outperformance of the equal-weight index is its greater exposure to smaller stocks. The plain S&P 500 Index is concentrated at the top. Only 10% of the names – 50 stocks – account for nearly one-half of the index’s total weight, and the largest 30% of stocks – the top 150 – account for 75% of the total weight. Conversely the smallest 40% — the bottom 200 stocks – account for only 10% of the index’s total weight.

An equal-weight index will elevate the exposure to the smaller stocks in the index, and this “size bias” explains a “considerable portion of the S&P 500 Equal Weight Index’s long-term returns,” according to the paper. Another smaller part of the explanation is related to the fact that the equal weight index undergoes periodic rebalancing. This means that stocks that have done well are periodically sold and stocks that have done poorly are purchased to keep the fund’s allocation equally weighted to the 500 stocks. So equal weighted indexes have a kind of “anti-momentum” strategy. And while momentum is viewed as a legitimate factor that can beat a plain index, so does an anti-momentum strategy. In fact, performance of the equal weighted index relative to its capitalization weighted counterpart can indicate how momentum is faring overall in markets in a given period, according to the paper. When momentum is doing well, the equal weighted strategy tends not to do well, and vice versa.

Another feature of an equal weight index is how it treats the sector components of the index. During the technology bubble of the late 1990s, technology stocks began to overwhelm the index in the sense of becoming a larger and larger component of it. And although an “equal-weight index effectively allocates to each sector in proportion to the number of stocks held in that sector,” according to the paper, this is enough to mute the bad or overwhelming effects that a sector run-up can have.

Overall, the evidence suggests that an equal-weighted index captures a greater share of the stocks that achieve above-average returns. This doesn’t mean such a fund should be the only stock holding in a portfolio. For example, it can complement trend-following or relative strength strategies, helping to increase a portfolio’s volatility-adjusted returns when used that way. An equal-weight strategy can also mute the tendency of a low volatility strategy to go through periods of underperformance.

Although the paper doesn’t characterize a capitalization weighted index this way, its analysis begs the question of whether such an index is itself a kind of a momentum strategy. In any case, investors should be mindful of the problems inherent in plain capitalization weighted indexes especially at a time when indexing is garnering so many investor dollars. Capitalization weighted indexer will do fine over time, if investors can stick with the approach through thick and thin. But, at some point, they might wonder why they didn’t consider alternatives.

Citywire Article: Can You Spot A Bubble? What About Now?

This is my most recent Citywire article on an academic study of bubbles. Despite what Eugene Fama asserts, they have telltale signs.


The return of volatility earlier this month set stock markets on edge, but are we really in bubble territory?