Questions about market efficiency have driven academic discussions for a long time and remain far from resolved, as evidenced by the 2013 Nobel Prize in economics, which was awarded both to Eugene Fama of the University of Chicago for his groundbreaking work on the efficient market hypothesis and to Yale's Robert Shiller for his fundamental contributions to behavioral finance, which point to the irrationality and inefficiencies in markets (Lars Peter Hansen, also of the University of Chicago, shared the prize).
As the debate continues, investors are, implicitly or explicitly, putting money on what they think the answer is. Roger Ibbotson, professor in the practice emeritus of finance at Yale SOM, explained the issue this way: "The whole notion of whether markets are efficient or inefficient is at the crux of how we manage money." Choices to seek alpha versus beta, take an active or passive approach, and concentrate or diversify all depend on the theory of markets.
This intersection of theory and practice served as the focus of a Yale SOM webinar on May 16. Ibbotson moderated a panel of asset managers: Ranji Nagaswami '86, Paula Volent '97, and George Wyper '84.
While all agreed that markets are generally efficient, they also see inefficiencies. "It really depends on the asset class you are talking about," said Ranji Nagaswami, a visiting executive fellow at the Yale SOM International Center for Finance and former chief investment advisor for the New York City employee retirement systems under Mayor Michael Bloomberg. "More importantly, it depends on the organizational structure you are operating within. I think this is a point that is heavily overlooked." She believes a realistic assessment of an investment team's skill sets is critical. "If you don't have the right people who actually know how to find alpha, if you don't have an investment committee that will stay the course," Nagaswami said, "then you should not be in the alpha business."
Volent, senior vice president for investments at Bowdoin College, also matches strategy to specific circumstances. "In really efficient asset classes, like fixed income, we would rather be somewhat passive and not pay extra for trying to generate alpha," she said. "In asset classes where we think there are informational inefficiencies, we prefer to invest with active managers and a lot of times we want those managers to have concentrated portfolios."
The historical data shows that fixed income managers offer little differentiation, whereas in venture capital, top managers have delivered significantly higher returns, Volent said. "Manager skill is something that we spend a lot of time trying to figure out, to separate the beta from the alpha," she said. "You can find alpha, but it is difficult." Often it comes from informational inefficiencies, which may be why top venture capitalists, who have inside tracks to exceptional entrepreneurs and new technologies, can offer a real advantage.
Volent also pointed out that there are structural efficiencies that nonprofit endowments, which aren't taxed and typically have long time horizons, can take advantage of. "Bowdoin is looking for inefficiencies related to investor differences," she said. When other investors must make choices around tax liabilities or short-term cash needs, it can be an opportunity for the endowment. Similarly, she noted, following the financial crisis, some institutional investors were forced to sell downgraded bonds in order to maintain minimum ratings requirements. For endowments with greater flexibility, that was a chance to buy.
A contrarian approach is also preferred by George Wyper, managing director of the Royce Funds. He relies on deep research into specific companies, he said, noting that while Italy's economy struggled after the crisis, there were individual well-managed, high-performing companies that were a value precisely because the country was seen as being in trouble. "We're pretty agnostic about what kinds of companies we invest in," he said. "Generally, we're drawn, at least in the near term, to companies, industries, and geographies that are out of favor."
Such opportunities are out there, Wyper said, but they are harder and hard to find. "There's no question the business has gotten harder," he said. "A, because there are so many more people in it, and B, because the flow of information has gotten so quick."
The increased competition makes it harder for everyone, but it may be retail investors that are most challenged. Earlier in her career, Nagaswami served as chief investment officer for the retail division of AllianceBernstein. When thinking about personal investing, she pays particular attention to behavioral economics research which has demonstrated that loss aversion is a powerful, and potentially misleading, driver. "The words 'buy low and sell high' are the most abused words in the retail investment business because we all buy high and sell low," she said. "You've really got to be able to link your beliefs to your implementation in order to succeed in the long term."