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Thursday, March 26, 2009

Efficient Market Hypothesis-- Maybe the Market isn't So Efficient After All

I am a staunch believer of Efficient Market Hypothesis (EMH), and my skepticism towards the claim that some Special Ones can time the market and make a better-than-risk-adjusted returns is well documented.  In my view no one can actually time the market and make better returns than the Index after factored in risk exposure, over the long run. Stock Market is like an ideal casino; no one can outsmart the house because all the games are just perfect probability exercises with no room for human error, no tricks that the players can exploit and the house always has a bit of unfair advantage because, err.., it's the house. In our stock market case here, each transaction will incur transaction fees, and bid-ask spread and they add up. Given that over the long run you can't do better than the average returns anyway, the more you trade, the more the fees will eat up on you and the more you will lose.  So as far as the investors are concerned, we have to reduce our trading costs and try to replicate the broad market returns, that's it. Forget about timing the market, forget about stock selection and forget about the trading secrets the charlatans sold you.

But the article "Top managers' pay dropped 48% last year" ( thanks to Dali) caused me to examine my long-time belief ( NYT also reported on the earning of those hedgies) .It seems that although Hedge fund top earners come and go, but there are several notable exceptions who consistently make it to the list, such as James Simmons and George Soros.

Let's talk about Simmons, his fund uses complicated mathematical models to predict the price movement of easily-traded securities and derivatives. What he's doing is dangerously coming close to the border of  technical analysis, a field that is long derided by academics as pseudo-science. But the only difference is while technical analysts ( or the chartists) are guilty of intentionally keeping their prediction vague, lest they were proven wrong, computer models are churning out precise results ( sometimes being precise about the wrong thing, how ironic). The fact that Simmons can use computer models to beat the market consistently means that maybe-- just maybe market prediction is possible, if you are smart and hardworking enough.

Or maybe not, the fact that Simmons can reproduce his stellar performance year after year may due more to the size he is, the connection he has and less to his computer models.  Because of their clouts, the hedge funds can always negotiate a lower transaction rate with the brokers. Because of their connections, they can always get breaking news a bit faster than the rest ( split second counts in high frequency trading). The mathematical models are just marketing tools; with or without them, the out-performers are going to get the kind of stellar returns they usually get.

Or maybe he's just plain lucky and the fact that his name pops up every year has more to do with survivor bias than any other thing else.

Any thoughts?

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