Monday, August 3, 2020

Efficient Market Hypothesis and Passive Investing

 When it comes to investing in the market, there is a lot of contentious debate about what is best. I have found that people get so wrapped up in defending their strategy that they either overplay the ideas behind the strategy or just outright misrepresent them. I understand wanting one's investment strategy to work best but let us not delude ourselves. "Best" is not something that is easy qualitatively to measure when various investors have different risk tolerances, timelines and goals.

The above is no less true when it comes to the Efficient Market Hypothesis (from now on as EMH); both from those for and against the idea of it. I think both (for and against) conceptualize EMH improperly and it takes away from the value it has as an investing strategy.

I will add that I have 90% of my investment portfolio invested in passive index funds, which are the products utilized by those that follow EMH and the studies following from it. That's not to say I'm biased toward it, but I think there is a specific way to look at this.

What is EMH?

It is the idea that stock prices reflect all available information available to the market. The corollary from this is one cannot beat the market. 'Beat' in this context means that someone cannot invest in a stock prior to the movement of the price based on the available information. This is to say that the price of any given security is rational (as opposed to irrational, random or subjective).

The scientific literature regarding stock picking has backed up this idea. The results show that on average, those that pick and choose underperform the market. Those that outperform that market, do it on luck and only outperform in specific timeframes - underperforming in other time frames. Studies like this has been done on brokerage accounts of individuals, as well as large players of ETFs and mutual funds. It has also been found that the increased cost of actively managed funds often always underperforms the market after fees. The studies have concluded that investments, when compared to the appropriate index and adjusted for the risk associated will underperform over the long run.

Lastly, there is the literal mathematics of the market. If it costs money to play in the market (stock trading fees), then more people must underperform the market than outperform it.

With this available scenario of the marketplace, EMH proponents contend that buying a cheap vanilla index fund is a far easier way to get decent returns without the risks that come with actively managing and underperformance. They also contend that one should buy and hold for the long run - instead of timing the market.

The Conceptual Issue with EMH

The problem I see with EMH, is the way people (proponents and opponents) look the concept of the market. The market is this 'thing' that is out there, and it is processing the information to rationally be at the correct price. The issue with viewing the market in this abstract manner is that it is not grounded to reality. It needs to be said that the market is not something out there. You, me and everyone participating are the market.

Prices are not driven by information. Prices are driven by buyers and sellers with that information. These people think and judge the information in such a way to determine what they are willing to buy at and what they would sell at.

The Way I View EMH

I like to think of it as the theoretical behavior of the market. It is like learning about gravity in physics. You drop a ball, do the math and can find out how long it will take to hit the ground. Of course, this is not truly how it works, as there is the friction of the air and not just the pull of gravity. EMH works in a similar fashion. It is not so much that the price is always proper, but that the price is always driven to the proper number. Figuring out whether you are on the right side or the wrong side of the number as it is being driven is another question.

This is where the context comes in: the market is not a thing, but the summation of all the people trading. What drives the proper price is the people in the market. And the question becomes, what do you bring to the table?

For example, let us say you are an electrician, you work hard, save your money and looking to save for retirement. You regard Microsoft as underpriced. Well what did you bring to the table? Probably nothing, right? The likelihood of having information the market does not have or the capacity to interpret the available information better is highly unlikely.

What if you are a seasoned medical researcher in vaccinations and other infectious diseases. Well you may have the capacity to bring something to the table. A new medical startup working on a vaccination for COVID19 may be doing the right approach (as you judge) and creating something that will pay off in the long run. This means a stock that is sitting at $10, you value at $50 and you keep buying until the price reflects that.

This is how EMH works with price. What do you bring to the table? That is the question. The average Joe is nothing. Most bank mutual fund managers do not bring much, if anything, to the table either. A Warren Buffett type may not be an 'expert' on various companies, but he has access to things the average Joe does not. While the average Joe can Google search (as if that is enough to put you ahead), Buffett has access to the corporate board, the CEO and in many cases government bodies.

My Issue with EMH Idealists

There are idealist people when it comes to EMH that act as if you, your mind, is impotent with regards to navigating the marketplace. I agree with the notion that beating the market is hard and in fact, I do not think that doing some Googling at your office desk in between work related items constitutes an advantage over others. I illustrated this view above.

This notion often translates into do not think, just put it in index funds. That will 'work' for the average person; work meaning producing a decent return over the long run to achieve some goal. Turning off your brain is turning off your most valuable tool. Index investing is not some commandment that must be followed, as if it is always true or right. It is a good approach to investing for most people trying to accumulate a nice sum of cash over the long run (for retirement as an example). You simply cannot follow an abstract rule, and not bring it down to reality where it lives. This requires you to think and deviate, as necessary.

Here are some examples I have come across:

1. Home Country Bias

I suppose this is somewhat of a contested issue with some people, me included. The idea is that since you live in a country, you should carry more than the typical market share. Several reasons break down as personal comfort or personal understanding. It is not just a view among index investors, but of the giant Vanguard declaring that home bias is good.

Studies have been done in numerus western countries such as the United States, United Kingdom, Canada, Australia, etc.

I am someone that has rejected this idea on the notion that it does not match with broad based vanilla index as a strategy. Sure, if you are an American and to a lesser extent the Japanese, this may not be such a big deal. The American market makes up 50% of the world market. A nice portion of the American market is made up of businesses that do business worldwide. Being biased in this sense is the broad-based vanilla approach.

If you are biased Canadian, which the Canadian market is less than 3% of the world market, you are heavy into a market dominated by financials and energy. This did not make a lot of sense to me, yet much of Vanguard Canada's all-in-one funds are heavily (ridiculously) in Canadian at 30% of the equities.

Ignoring that, what if you are someone that is investing from Iraq? Do you just dump in a home bias into the marketplace that is Iraq? Never. I could never do that because I cannot turn off my brain.

2. Shareholder Activism

This is something new and something that many funds are facing or have already faced. Personally, I have experienced this with my holding of VTI (I believe it was this one). What happens is a group of activists get together, maybe buy some units and lobby the fund/management/business to change their investment policy to exclude certain businesses from their funds. Obviously, something getting genocide out of the game is good, but you can imagine how political this will become in the future. Activism will extend to things like energy companies and climate change, and other politically charged activism such as divesting from Israel.

If your investments are getting politically high jacked, you must think about what you are going to do.

Also, this does not just hit funds, but the indexes that are created. Activism is something that is going to skew the notion of a passive index fund. And onto the next point.

3. Indexes are still curated

The strategy is to follow passive broad-based vanilla index funds, rather than actively managed funds, but indexes do not just happen - they are actively created. They have criteria and they are executed to that extent - though the criteria do change over time and securities come/go.

The only difference between the creation of an index and an actively managed fund, is that the index is for capturing a market at a beta of 1 and actively managed a portfolio at an alpha greater than 1. Both have someone at the wheel, thinking and deciding how to allocate capital. You cannot declare yourself as outside of all of this, you still need to think and know that those navigating the field are competent for your investment.

4. Everyone in the market cannot be passive

Having passive participants in the market is something that works if it does not make up too much of the market. Studies and expert opinions would need to be consulted to figure out what that exact number would be before having issues. There needs to be people out there making decisions and plays that price things different than the current passive price now. Everyone cannot be passive. An analogy of this would be the advice to buy a used car that's 2-3 years old with low mileage. It is good advice, but someone must be out there buying new cars or there will not be any used cars to buy.

A common rebuttal for this I have heard is that this is not something likely to occur because there will always be an appetite for risk takers. I agree with that sentiment, but I think proponents of EMH need to accept that active risk taking is good and not something to be looked down upon as 'stupid' or a guaranteed below market return. At some point, someone has to discriminate with their money in the market, ie: Microsoft is getting all my capital and not Amazon because they have better fundamentals - rather than investing it on market share without any regard for the businesses.

5. China & other regimes

The whole philosophy behind passive investing is that you want broad based vanilla index funds, but how far do you take such the notion of broad? Well, some at the larger fund providers such as Vanguard and iShares think the international components need to include more China. China makes up a large chunk of the world market, but the state has only allowed some access to the market. Both VXUS and IXUS both hold over 10% China. There is a possibility of further access, which will increase this share.

I am not a fan of being invested in China. The authoritative communist regime is extremely oppressive and anti-Western. It is also important to point out that business in China operates in a constant gray area. All businesses are legal and illegal, which is suspect for carrying out any meaningful work. The ability to profit is dependent on greasing the right wheels in China's oppressive government.

Lastly, larger businesses are the ones bought up due to the nature of being large enough to be in stock exchanges. It is pretty much confirmed that once a business grows beyond a certain size, the communist party becomes part of the business.

This is true of other regimes such as Saudi Arabia. These oppressive regimes, outside of China, make up very small portions of the market that they are negligent, but if they are negligent, I do not need them.

I have personally divested a portion of VT (Total World Stock fund) for precisely this reason. I do not like the idea of owning Chinese banks and Huawei. That is not to say I think business related to China is bad. I am not interested in investing in China, but a company like Apple does sell phones in China which I think is an appropriate way to be invested. The criteria for me is whether business is something that acts with relative freedom. All countries operate in some mixed economy, but there is a difference between a place like Norway and places like China and Saudi Arabia. The latter function, not as independent agents of a business, but wings of the state and by the graces of the state.

I am still trying to figure out what to do with my remaining VT. I want international equities, but I am not entirely sure how I want to approach this problem.

My Thoughts on EMH Opponents

I was planning to write something much more in depth, but I decided to save that for another article as it would not be about EMH. There are two points that I wanted to address as I felt these seemed to creep up in one manner or another.

1. My way of investing is the best way of investing

This is something EMH proponents also partake in. A lot of people just invest the way they have reasoned to be the best approach and that is all they are interested in. They do not care about what other people are up to. However, other people have invested a lot of esteem in their strategy by the approval and acceptance of others. They often discuss in groups of likeminded investors in a nice self-congratulatory circle of greatness for their style of investing.

I regard these people as emotionally driven and rationally weak.

2. Prices are irrational

In one way or another, many opponents of EMH reject it on the notion that pricing is rational. EMH holds that the price is driven by information in real time to reach a price - which is rational. People often say, "look at the dotcom bubble" and that is an example of irrational pricing. This is true in a sense. Much of this anomaly in pricing is driven by the availability of cheap cash and the self-congratulated mass of easy returns.

This momentary irrationality is something that does correct itself. Just because there were times of irrational pricing, does not mean prices are irrational as a whole. It also does not present an investor with information about when to be in or out of the market. Accepting prices as not rational is to regard the market as a game of whim and chance. A person that regards a market like this are better off going down to the local casino and take a shot at various games of chance.

The reality of pricing, even during a bubble, is still rationally perceived. Stock prices are driven by the fundamentals today, the direction of the company and where one judges it to be in the future. The future judgment does not always pan out as anticipated. The vision does not actualize. The market pivots with new tech (such as crude oil vs LNG). The peaks of the dotcom bubble were exaggerated by cheap cash - both by institutional investors as well as a new breed of investors known as the average Joe.

Conclusion

EMH is a simple idea; the market is driven by the available information to reach a rational price on securities. Unless you have something to bring to the table beyond what is available in the general pool of information, the likelihood of beating the market is low and a game of chance. Emotional investors are the ones that jump from whatever hot item, popular buy or trending company and find themselves losing - when compared to someone that buys and holds. Even big institutional investors fail to beat the market over the long run and charge you a pretty penny for that.

The theory has led many people to passive index investing. Instead of playing this game, trying to beat the market by doing endless Google searches or paying some mutual fund manager a pretty penny is not the best way. Simply buy a cheap passive broad-based index fund that returns roughly the market.

Within context EMH is not some authoritative law based in nature or commanded by 'god'. It is a way of viewing the marketplace in theory and what the expected behavior would be. Information, in and of itself, does not drive prices. Investors with information are the ones that make the judgment calls that drive the prices rationally in the appropriate direction. This is the key to understanding EMH, not as a commandment, but as a way of understanding how this complex system works.

Being an average Joe, you work a job, you have a family, you like chicken wings, you are better off just investing passively. It will result in good returns and help you reach your goals (enough money for retirement). Those that have risk appetite or bring something to the table (expertise and knowledge) have the capability of venturing out in the market and discriminating with their money. Someone must decide that Company A deserves more capital than Company B. It cannot always be a market cap purchase.

EMH gives people an understanding of the market, for both passive investors as well as those that make plays. Pricing is rational and investing requires rationality. It is not one style over another. It is about what you do with the knowledge that leads you to the best outcome for your goals, desires, timeline and risk tolerance.

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