CFA Institute

Reflections on Market InefficiencyAuthor(s): Dean LeBaronSource: Financial Analysts Journal, Vol. 39, No. 3 (May - Jun., 1983), pp. 16-17+23Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478640 .

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by Dean LeBaron

*utlucliuhu un Market I.uliciernc

P HYSICISTS AND BUDDHISTS tell us, and most rational people know, that absolutes are only an illusion. But our egos are more

attracted to Newton, who would tell us that there is such a thing as absolute scientific precision, and that we are approaching it. Such is also the case with investors and "market inefficiencies." We astute, value-oriented investors would like to believe that we can detect and take advantage of departures from some absolute standard of mar- ket efficiency. We want progress toward New- tonian rationality to prevail, to our worthy prof- it and to the loss of the less well informed and less astute. Calvin should be correct: God's reward is on earth as well as in heaven.

Of course, we usually consider the pricing mechanism to be inefficient only with respect to some ego-based reference standard. In other words, that which is efficient is what we believe to be right, whereas that which is inefficient is what we believe to be not right. That said, however, I'll now proceed to outline six market inefficiencies, or characteristics of inefficiencies. Each has features of value that are readily recog- nizable, but most are unlikely to be exploited. That's what makes any inefficiency and allows it to last even after recognition.

Agents Why are there such aberrations as closed-end funds persistently selling at a discount and not liquidating? Why are premium prices paid in mergers and acquisitions? Why do new issues yield abnormal returns? How can knowledge of insider transactions, even when publicized, have investment value?

There must be something going on in practice that is not accounted for in theory. To be sure, no one any longer expects the markets to be ab- solutely perfect, but are they so inefficient that these large aberrations can exist and even per- sist? Is it a manifestation of the small firm effect?

Or some other missing variable in the Capital Asset Pricing Model?

I offer a hypothesis that may be classed as the "theory of agents." It is related to the idea of the agency costs that arise in the separation of the ownership from the management of the firm, but it involves a different intermediary.

Most payoff systems should be designed so that agents are motivated by the same things the ultimate wealth holder would be motivated by. But institutional markets appear to be heavily influenced-even dominated, if we believe the popular literature-by individuals such as pen- sion managers and investment managers who are not proportionately enhanced by the investment gains from individual transactions. Rather, they have a somewhat different set of payoffs. Their clients' perception that they are capable is one element in this set. Because of this, some good investment decisions are known but not done because they are not acceptable to the client. The guiding principle in this environment seems to be that it is better to make a little money conven- tionally than to run even the smallest risk of los- ing a lot unconventionally.

The Capital Market Line, as measured in prac- tice, tells us that investors pay more for downside protection than for upside gain. Why? Is it because we all have to face committees, hence do not act as our trustee and fiduciary charge would have us act-i.e., as reasonable businessmen would act for their own account? Are we willing to forego somebody else's investment gain for our career gain? Many managers end up paying a good deal in terms of foregone opportunity for the privilege of resting comfortably in the lower part of the second quartile and avoiding ever be- ing in the bottom quartile for even a short period.

Of course, the pension officers-our clients are themselves agents. They often behave in ways that may be uneconomic to beneficiaries. Take for example, the growing use by pension sponsors of multiple managers, with its corollary of having sharply rising costs. There is little evidence that aggregate results improve enough to justify the expense. This phenomenon may be

Dean LeBaron is President of Batterymarch Financial Management. This article is adapted from his remarks to the Institute of Quantitative Research in Finance conference in Scottsdale, Arizona in October 1982.

FINANCIAL ANALYSTS JOURNAL I MAY-JUNE 1983 g 16

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best explained in terms of the sponsor's desire to minimize short-term career risk from volatili- ty by diversifying across many managers.

Early last year, our firm introduced a new strategy called "Corporate Recovery." Our clients had reason to expect that we would be at- tracted to contrary investment notions, so it was consistent for us to buy beleaguered companies in packages at a time when illiquidity was a front- page peril. Most of our clients acceded to our wish to try the strategy, but only after great soul- searching. We were told that, although the strategy made sense for a businessman on his own account, it was inappropriate for agents.

Obviously, some forms of money-making are considered out-of-bounds for agents, and the losers are the ultimate wealth holders.

Small Stocks The small stock effect has been analyzed and reported by academics. Investors know now that small capitalization stocks should yield excess return. Maybe this return is related to liquidity, maybe to taxes, or price-earnings ratios. Perhaps, more likely, it relates to the cost of obtaining rele- vant information.

No matter. What's interesting is that the academic evidence, to my knowledge, did not become known until the late 1970s, well after the greatest bull market in small stocks was mature. I can well remember discussing market imperfec- tions (as we called them then) with clients in the mid-70s, when investing in anything other than the Nifty Fifty was considered imprudent. Academic evidence would have helped more then.

Perhaps investigative attention is influenced by receptiveness. If so, inefficiencies cease to exist just where and when they are well documented to have been present. The studies may be like traces of high energy particles in a cloud chamber: True selection has already passed through.

Cost Evidence tells us that individually managed assets perform better than institutionally man- aged assets. In my view, the 1 per cent or so of underperformance sustained by institutionally managed money year after year must be traceable to costs. Why does it cost so much to manage money? After all, one might rationally expect that institutional management would benefit from economies of scale not available to individual

investors. Opportunities for cost savings do exist. Trans-

action costs can be driven down, yet too few managers make the effort to do so. Can it be that the cookie jar is too much of a temptation for the economic Invisible Hand?

Of course, clients themselves may be to blame. If they emphasize short-term returns, they are likely to encourage higher turnover rates. If they use multiple managers, they are likely to pay more in management fees, in many cases, without receiving any commensurate increase in return. Our own experience has been that management fees just don't seem important. Our firm offers, for example, a sharply tapered fee schedule. Now, it may be that client estimates of our likely investment outcomes are commen- surately modest; nevertheless, we have seen lit- tle evidence that our fee policy has any positive business effect.

It appears to me that academics have applied their skills more to the development of strategies than to day-to-day cost savings. Some of these strategies, such as index funds, have indeed led to cost savings. I think this area would prove fruitful for further research and application.

Investor Group Uniqueness There appear to be different sets of payoffs for different market participants. I see no reason why tax effects, for example, shouldn't affect pricing. The evidence admittedly seems sketchy, but there is a theory in real estate that states that prices are set by the single most advantaged in- vestor, that no other investor counts. Maybe this is true in public securities markets.

Furthermore, the quest for wealth maximiza- tion seems to be influenced more by expected consumption than by new accumulation. Surely payoffs are important to investors not because they result in nominal enhancement on a report, but only insofar as they lead to changed patterns of behavior. Possibly shifts of dominance from one group of investors to another may result in apparent inefficiencies, almost as a particle shifts from one plane to another instantaneously.

Time Most models assume that time is a constant and that payoffs are the same through time. The assumption of "continuous time" is undoubtedly inapplicable to the real world. Investment horizons differ across investors and differ over

concluded on page 23

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1983 E 17

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Table I Index Characteristics

S&P 500 HA Index

Large Capitalization Stocks 43% 33% ($5 billion or more)

Smaller Capitalization Stocks (under $5 billion) Superior Growth 30 57 Average-to-Low Growth 27 -

Cash Equivalents - 10

100% 100%

Beta (Including Cash) 1.00 0.98

strategies implemented by the manager cause the portfolio's performance to diverge from the in- dex. If the universe has been appropriately iden- tified, however, the index should provide a more realistic standard of measurement for portfolio performance than the returns of a market index unrelated to the manager's method of operation.

Advantages The introduction of an individual universe for each manager helps to fulfill two of the most

critical requirements of the plan sponsor. First, it permits the sponsor to achieve improved con- trol of total fund diversification. The plan spon- sor, through allocation of funds between mana- gers with differing universes, determines the combination of universes that makes up the total fund. While the individual manager is account- able for portfolio performance relative to his universe, the plan sponsor determines represen- tation in a particular universe when he selects a manager who operates in that universe. The plan sponsor, rather than the portfolio manager, is therefore accountable for the performance of the universe itself.

Second, the manager universe helps the spon- sor to arrive at a realistic appraisal of the manager. To the extent that a manager's universe is properly specified, the success of his invest- ment strategy is indicated by the performance of his portfolio relative to the universe in which he has chosen to operate. He is neither rewarded nor penalized for the performance of the universe itself. As a result, the manager is encouraged to concentrate his efforts in the areas where he believes he can demonstrate special strengths. M

Reflections on Market Inefficiency concluded from page 17

time for the same investor. There are days when the market appears to be discounting events five years out. Then there are days when its ability to discount seems three months back.

Our ability to model the time function is still very poor; when it improves, this inefficiency too may disappear.

Forecasting from Price We know that economic forecasting, although the prologue to any investment firm's presentation to clients, is not the most intelligent way to ar- rive at an investment strategy. Corporations, on the other hand, compete desperately in getting an edge in economic forecasting and, in fact, need

economic forecasts to run their operations. But the market is much better at forecasting the economy than economists.

My suggestion is to read out from prices an economic forecast that might be used for business planning and corporate strategy. Maybe we've been working the problem backwards.

Conclusion These six inefficiencies are grounded in indif- ference, or in discomfort with some of the methods that could lead to wealth enhancement. They exist because we do not root out their basic causes. These causes are easy enough to identify, if one looks with enough dispassion and rigor. If the academics point to them, the rest of us can respond and ... walk by. E

FINANCIAL ANALYSTS JOURNAL / MAY-JUNE 1983 r 23

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