Asset Prices Consistently Violate Efficient Market Hypothesis

by Liron1 min read28th Jul 20202 comments


World Optimization

Lyall Taylor points out two reasons why asset prices consistently violate the EMH:

(1) Liquidity flywheels make the market inefficient from a long-term value perspective, because shorter-term momentum dynamics exist for structural reasons decoupled from underlying asset values

(2) The cost of capital in various assets is determined by a coarse-grained bucketing into leaky abstractions like “listed equities”, and there aren’t many participants capable of arbitraging when the specifics of an asset defy their category bucket, due to structural forces of short time horizons and fund management principal-agent problems

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I think this is based on a misunderstanding of EMH. There's no claim that the efficient price matches some other calculated "fair" or "value-based" price or whatever metric you think is violated. There is only the claim that all available information is incorporated into the price, so there's no exploitable (predictable) variance. Except private information, and by exploiting that, you incorporate it into the price.

There ARE good arguments against the EMH, including illiquidity/thin-ness, and large-scale mis-modeling (where a significant portion of the market is ignoring or mis-using public information). "The market can remain irrational longer than you can remain solvent" is age-old advice, and pretty darned valid.

But this article doesn't seem to make those arguments very well.

There is only the claim that all available information is incorporated into the price, so there's no exploitable (predictable) variance.

The author gives a specific example of an exploitable price: The stock of Hong Kong Land, where the underlying real estate assets are being priced at 25 cents on the dollar because they're packaged into a listed equity.

His claim is that anyone buying this equity at its current price is exploiting the market by a factor of 4x by achieving an equity-like 10%/yr return, but with the low risk/volatility of a 2-4% real estate asset or close.

He claims that this price inefficiency persists because there aren't many people in a position to hunt for and invest in these kinds of arbitrages, because funds often structurally restrict themselves to investing in one type of asset class (i.e. leaky abstraction). So in this case, the inefficiency persists because there are not enough fund managers like himself: competent enough to recognize attractive real estate investments but not structurally limited to the Real Estate asset category.

I don’t think this summary does a sufficient job of capturing the nuance of the argument being put forth. It also might be giving the impression that the critique is based on a misunderstanding of EMH, which his first paragraph well states. The author is directly claiming there is a clear mis-pricing in assets that offer a greater than total market risk-adjusted return. It is one thing to claim he is talking his book, which he is, it is quite another to ascribe ignorance to the view articulated without reckoning with any of the arguments.

Momentum as a factor is hard to explain under EMH because if the current price incorporates all known information, how can the time series of price information contain a trade-able edge?

The example of HKL is put forward, which is a holding company for prime real estate in Hong Kong and Singapore. The stock trades at valuation of only 25% of the most recent market value of their net real estate holdings. There are many possible reasons for this, and it is fairly common for holding companies to trade at a discount to their net assets. The author argues this is due to an anchoring type effect. The shares of HKL are traded on an exchange among other stocks. The salient benchmark being the rates of return of the rest of the equities in the market. To match the higher yields available from other equities HKL must trade at a discount to book.

The underlying real estate assets are being valued differently on the open market. Here a 4% yield looks great if the salient benchmark is fixed income, which is reasonable because of the high quality of the cash flow. If both of these are true the same asset is being valued differently based on the market it is being traded in. This not only violates EMH, but also the law of one price. This is an arbitrage opportunity but the onus is on a market participant to articulate and execute the trade that captures this opportunity.

Crucially he is not arguing the market is not incorporating public knowledge efficiently. The argument states there are principle-agent problems writ large in financial markets the allow for persistent mis-pricing of assets. To capture these opportunities you don’t need better knowledge but a better structure than the average market participant.

Whether EMH is true or not, it seems to get a lot of free credit as a theory. It proves so little and commits its adherents to so much. I think its popularity may lie more in its beauty than in its truth.