Peter Bernstein is one of my favorite finance writers -- if such a category exists. Many might recognize his name as the author of an improbable bestseller a few years ago,
Against the Gods: The Remarkable Story of Risk
, which is another must-read for those who have any intellectual and financial interest in how the human brain and financial markets collide. Peter is a longtime observer of the financial scene and hangs his hat at a firm that bears his name, selling expensive research services to institutional types.
It has been said that stealing from one source is plagiarism, while stealing from many is research. On that note, I'll fess up and state that much of what follows is a modest summary of Bernstein's recent article, titled "Why the Efficient Market Offers Hope to Active Management," in the
Journal of Applied Corporate Finance
, Volume 12. (Yes, that's what we southern California money managers do at the beach.)
You can imagine my interest as a value manager who until very recently was having an invincible year -- the first in several.
For a smart guy with a Ph.D., Bernstein does a nice job of kicking the efficient market theory to shreds. He does this primarily by agreeing with a key theme to be found in the lyrics of
: that the future is uncertain. (The musician also believed, like Jim Grant of
Grant's Interest Rate Observer
, that the end is always near.)
Bernstein recalls Eugene Fama's truly efficient market as one whose pricing "immediately" and "fully" reflects "all" available information and that instantaneously translates new information "correctly" into "equilibrium" prices. It then follows that the future is "bimodal": Either things work out exactly as the current information suggests and prices never change; or a future event is a total surprise, and prices move instantly to the new level. In Bernstein's words:
The payoff for being smart is zero. Information moves so quickly and so accurately into asset prices that no single investor or a group of investors can consistently outperform the market except by luck ... no investor can acquire more useful information than the information in the marketplace, no investor can receive relevant information sooner than other investors receive it and no investor has the capability to evaluate it more reliably than other investors. Prices change too rapidly for such opportunities to be available.
I would like to think that we all agree that this is a silly theory. Even before the advent of the Internet, information was all over the place -- and was worth different things to different people. As I have noted a number of times in this space -- and the
is right behind me now -- some people do get information before others. And do we really believe that a market of "greedy, perspiring, anxious human beings with varying degrees of risk aversion, intelligence, decisiveness and investment objectives" is 100% accurate in setting correct prices all the time?
Having dismissed the idea of the efficient market, Bernstein then asks "whether the whole process of acquiring, evaluating and acting on information is worth the effort" and the money. Bernstein answers yes. (I
I liked that guy.) Since the future has been, is and will always be uncertain, there is marginal utility in gathering information to at least understand the rough boundaries between risk and reward. He paraphrases an old-time investor, Jack Treynor, who said that you may not get rich doing research, but you have high odds of becoming poor if you don't.
Getting back to the real world, the relevance is that we have an enormous clamor from some camps for "indexing" in the name of market efficiency, and yet we have some of the largest valuation disconnects in modern history between certain groups of stocks. How can both exist simultaneously?
Bernstein points out that the gap by which the top 20% of money managers has beaten the
has consistently narrowed since 1984 and correctly notes, in my opinion, two issues here. The first is that the investment business
become tougher in many ways. The sheer amount of intellect, dollars and scrutiny being thrown at the market does mean that much of the market is efficient most of the time. That's why this is
an easy business, Internet newbies aside.
But he also brings up something that I've noted in this column before: The
of money management is itself grinding down extraordinary performance. The goal has become in many cases a game of "retain the client," and the easiest way to do that is to closet index the benchmark. Just as a pure index fund has trouble perfectly replicating the index due to management and transaction costs, an active manager will find it tough to beat the index by making numerous numbers of minor changes. You must do something different to outperform.
It's a classic chicken and the egg: Has the client world become much shorter-term -- putting the investment manager under pressure to produce results that don't deviate from the index? Or is the investment management industry running money that maximizes revenue generation rather than performance? I think it's historically clear that the best results are generated when great clients let great managers truly do their thing and give them time to do it.
Money management is no different than any other human endeavor. On the driving range, you can hit 31 perfect drives in a row (OK, maybe eight, and that's on a good day). Surround the same player with 20 people watching on the first tee, and it becomes much tougher to do what he or she is capable of. Tell them that if they aren't at par for the first four holes, they can't finish the 18 and you will singlehandedly end the five-hour round.
This has been an extraordinary time, and despite a lot of intellectual carping, I certainly hope an approximation of it continues. But things have not been as good as some of the popular averages indicate. The S&P 500 may be up 9.6%, but the median stock in the index is down 6% for the year; 40% of the stocks in the
are down more than 10%, 30% are down more than 20% and 20% are down more than 30%. Some of the money managers with the best 20-year track records are having careers destroyed by the enduring narrowness of the market.
There continue to be China-sized gaps between the valuations of the 100 or so largest stocks and nearly everything else. In my humble opinion, this market is as inefficient as any since the 1973-74 bear market, which coincidentally began one of the great trend shifts in postwar financial history. Nor is the future anywhere near as certain as
shareholders have priced it.
Almost by definition, achieving long-term outperformance means doing something the other guys aren't ... and of course, getting it right. Focusing on what is loosely defined as value and smaller companies right now is clearly a strategy that satisfies the former. I also believe it will be the latter.
Jeffrey Bronchick is chief investment officer of Reed Conner & Birdwell, a Los Angeles-based money management firm with $1.2 billion of assets under management for institutions and taxable individuals. Bronchick also manages the RCB Small Cap Value fund. At time of publication, neither Bronchick nor RCB held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Bronchick appreciates your feedback at
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