Efficient Markets? Hah!
Justin Fox
03/01/1999
Fortune Magazine
40
(Copyright 1999)
So Nobel laureate Myron Scholes has left Wall Street (actually
Greenwich, Conn., which is pretty much the same thing, only with
trees) and gone home to San Francisco. His experience at Long-Term
Capital Management, the now-infamous hedge fund he helped found, has
taken much of the sheen off his reputation. It may do the same for
efficient-markets theory, the rock upon which Scholes and a
generation of finance scholars and practitioners have based their
work.
Efficient-markets theory, to crib from Scholes' 1997 Nobel
lecture, "states that, in a well-functioning capital market...the
best estimate of the value of a security is today's price." This
insight, associated most closely with Eugene Fama, a University of
Chicago professor who taught Scholes in the 1960s, revolutionized
finance. It led to the index-fund phenomenon and enabled Scholes and
Fischer Black, another finance scholar who later went to Wall Street,
to devise the options-pricing model that created the derivatives
industry.
The theory was also indisputably sound, up to a point: It is
really, really hard to consistently beat the market. But efficient-
market true believers take this a step further, to the conclusion
that financial markets are therefore always right. And as Deputy
Treasury Secretary Larry Summers argued in one of the more important
works of his past life as an economics professor ("Does the Stock
Market Rationally Reflect Fundamental Values?" in the Journal of
Finance, July 1986), there's absolutely no proof that this is so.
Markets sometimes go wiggy in ways that efficient-markets theory
simply can't explain.
In an efficient market, to quote again from Scholes' Nobel
lecture, "securities with similar economic risk {have} to exhibit
similar returns to prevent arbitrage profits." Real markets aren't
perfectly efficient--trading costs and other factors allow small
inefficiencies to pop up. At LTCM (and other hedge funds and Wall
Street firms), the strategy was to exploit these little anomalies--a
difference in risk-adjusted returns between, say, U.S. Treasuries and
Danish mortgages--betting that before long, market efficiency would
reign again. As investment strategies go, this was a pretty
conservative one--so conservative that the only way to make it pay
off was to use gobs of borrowed money. But that leverage was seen as
a reasonable risk, because remember: Markets are efficient.
Then, last summer, panicked investors the world over began buying
U.S. Treasuries and selling everything else. The price discrepancies
that LTCM assumed would disappear instead grew, at least temporarily.
The banks that had advanced it billions of dollars got scared and
called their loans. The once-proud hedge fund had to submit to a
takeover by its lenders. It was all terribly irrational and
inefficient. Sometimes markets get that way.
--Justin Fox |
