Hedge-Fund Genius Isn't Really Sold on Hedge Funds

Markets may not be efficient, but they're probably efficient net of fees.
Cliff Asness. Photographer: Jonathan Fickies/Bloomberg

Here you can read 10 internet pages about the efficient markets hypothesis by Cliff Asness, who runs the quant hedge fund AQR Capital Management, and John Liew, another founding principal of AQR. You can probably figure out for yourself if that's the sort of thing you'd enjoy. I enjoyed it very much, so I give it my usual conditional recommendation, the one where if you like what I like you'll like this thing I like. You will! If.

I also give it an additional conditional recommendation, which is that if, like me, but even more like a lot of other people, you spend some amount of time snarking glibly about market efficiency, or pointing to dumb stuff like Nest/Nestor and saying, "so much for your efficient markets har har har," you really ought to read Asness and Liew's piece. It discusses the joint Nobel Prize awarded to Eugene Fama, who's largely responsible for the efficient markets hypothesis (and also for teaching Asness and Liew economics), and Robert Shiller, who's a critic of the EMH and a behavioral finance pioneer, and it does a good job of laying out exactly what it would mean for markets to be efficient, and why it's not as simple as it sounds:

To be able to make any statement about market efficiency, you need to make some assertion of how the market should reflect information. In other words, you need what's called an equilibrium model of how security prices are set. With such a model you can make predictions that you can actually observe and test. ... You cannot say anything about market efficiency by itself. You can only say something about the coupling of market efficiency and some security pricing model.

Market efficiency means that "security prices fully reflect all available information," but you need a model of how they reflect that information. And so Asness and Liew walk through various "anomalies" -- that value stocks outperform what a simple capital-asset pricing model would predict, or that momentum investing can outperform simple indexing -- and weigh whether they reflect "inefficiency" or rather just inadequate pricing models. Does the value of momentum investing mean that investors are irrational and that stock prices don't rationally incorporate all available information? Or is there some rational pricing model that says the above-market returns earned by momentum investing is compensating for some risk not reflected in simpler asset pricing models? How would you tell the difference?

The answer is ... I mean, it's 10 internet pages, go read the piece. I guess the spoiler is, the answer is "a little of both": There's some behavioral irrationality in markets, but the EMH is more powerful than you might think from some of the glib criticisms sometimes leveled at it.

My last conditional recommendation is that you should read this article if you (1) have money, (2) invest it with some professional money manager and (3) expect that money manager to provide you with above-market returns. 1 Here is a fascinating passage:

So if markets are not perfectly efficient but not grossly inefficient either -- though occasionally pretty darn wacky -- what should investors do? We believe the vast majority would be better off acting like the market was perfectly efficient than acting like it was easily beatable. Active management is hard.

That's not to say we think it's impossible. Take, for instance, our favorite example, briefly mentioned earlier, of people who seem to be able to consistently beat the market: Renaissance Technologies. It's really hard to reconcile their results long-term with market efficiency (and any reasonable equilibrium model). But here's how it's still pretty efficient to us: We're not allowed to invest with them (don't gloat; you're not either). They invest only their own money. In fact, in our years of managing money, it seems like whenever we have found instances of individuals or firms that seem to have something so special (you never really know for sure, of course), the more certain we are that they are on to something, the more likely it is that either they are not taking money or they take out so much in either compensation or fees that investors are left with what seems like a pretty normal expected rate of return. (Any abnormally wonderful rate of return for risk can be rendered normal or worse with a sufficiently high fee.)

This claim that even good investment managers are never worth their fees is really interesting to read coming from, you know, two hedge fund managers! 2

It's also fun on its own, though. It's a sort of claim of market meta-efficiency: The markets for investments may or may not be efficient. But anyone who can find and exploit the inefficiencies -- who can make abnormally high returns for a given level of risk -- will charge for that ability. And, sort of by definition, that person will be good at exploiting mispricings. And so if he's providing you with a risk-adjusted excess return of, say, 5 percent a year, but only charging you 2 percent a year, then that will look, to his well-trained eye, like a mispricing. And so he'll raise the price to 5 percent. And then all of the excess gains will go to him, not you. 3 Even if you have doubts about market efficiency, market meta-efficiency might be enough to turn you off to active management.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.
  1. I think this is a small group? Of my readers, I mean, not of the world. For instance, I bet the overlap between this group, and the group of people who will click over to read things I enjoyed on the strength of the fact that I enjoyed them, is basically nil?

  2. They walk it back a little in the next few paragraphs. Invest with AQR, it's great, they have a robot Warren Buffett. Also this snark is a little unwarranted; Asness regularly criticizes hedge fund fees.

  3. "Well then, I'll just beat the market myself," you say. Okay fine.

    Oh by the way it's worth noticing (?) that this argument doesn't run in reverse. The market for good investment advice, on this model, is efficient: It's very rare, and the good investors are good at understanding value, so they can charge 100 percent of the value they add. (Incidentally there is some empirical evidence against this proposition.)

    But the market for bad investing advice need not be efficient: It's very common, and the bad investment-advisor customers are not good at understanding value, so they'll happily pay investment advisers fees that lower the net risk-adjusted returns to well below what they'd get from indexing. Finding empirical evidence of this is left as an exercise for the reader, but it should be a very easy exercise.

(Matt Levine writes about Wall Street and the financial world for Bloomberg View.)

To contact the author on this story:
Matthew S Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Toby Harshaw at tharshaw@bloomberg.net

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