Thursday, March 10, 2011

Something I Just Now Learned about ECMH

Here's a point about the much-maligned Efficient Capital Market Hypothesis that just sank into me while reading Sebastian Mallaby's More Money than God.  But first, a shout-out for the book: it is a splendid piece of work, as carefully-thought-out and fully-informed as any piece of finance journalism I can remember.  Plenty of credit to Mallaby, although I suspect that a lot of credit goes also to his handlers at the Council on Foreign Relations, who appear to have given him the kind of backup (= time and money, etc.) that most journalists can only dream of.  But as I say, the real point is that he used it well.

Anyway, to the point at hand.  Mallaby is insistent--one might say to the point of tendentiousness--that hedge funds disprove ECMH.  He's probably right here, even if he does overdo it a bit. But the insight, for me,, concerns the kind of skill or knowledge that successful hedgies bring to bear, so as to earn alpha returns.

My point is that the vast majority of the successful hedge fund operators appear not to have focused on individual securities so much as on markets as a whole.  Their skill, in short, is not the Ben Graham value investor skill: it is much more a mastery of the poker-playing, head-butting, roller-derby turmoil of the trading arena.  That seems almost definitionally true of somebody like Paul Tudor Jones, who got his start in the cotton exchange.  I'd say it is equally true for George Soros' seemingly inborn knack for understanding a market as an N-dimensional Rubik's cube.   Even a trader like Julian Robertson who may appear more closely wedded to the equity market, seems to have made his money as much from his grasp of the "market" part as of the "equity."  As if to further the point,  Thomas F. Steyer may prove the role by indirection: he seemed to do almost everything right until he got bogged down in a Colorado land development project, finding himself coping with the cares and disappointments that are bound to face almost any front-line entrepreneur.

I don't pretend to offer any blazing new insight here.  And I don't mean to be understood as "exposing" the hedge fund industry.  I tend to agree with Mallaby that the hedgies acquitted themselves rather well in the late uproar and maybe one thing we can do to ease the pain on another day is to encourage them to do more of the same.  I'm just struggling for a point about what it is that ECMH does and does not comprehend.  I suspect my point (if any) is that there's next to nothing in ECMH about market (for lack of a better word) "structure" and how it may affect pricing.  Yet it is these insights about "structure" that provide some of the most interesting insights into the degree to which ECMH may not tell us much at all.

Side note: I can see that when I start talking about "structure," I'm veering perilously close to what the chartists do--head and shoulders, cup and handle, flag and pennant, all that stuff.  I know that any self-respecting academic will regard charts with contempt--will tell you that it is impossible in principle for the charts to be correct, and that not a shred of evidence can be found to support the chartist's view. Yet it is remarkable how many of the successful hedgies some to go around with a bunch of charts under their arm. 

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