Tarnishing the Efficient Market Theory

You’ll find lots of entertaining and enlightening things in the latest quarterly shareholder letter from GMO, the large institutional investment manager. Co-Founder of the firm, Jeremy Grantham, enjoys criticizing this year’s co-winner of the Nobel Prize for Economics, Eugene Fama, for the efficient market theory and all that follows from it. Grantham says the theory obviously was wrong, and that co-winner Robert Shiller contributed more to economic thought than Fama. But Grantham does thank Fama for, in effect, making Grantham wealthy. He says Fama’s work discouraged a number of bright people from trying their hands at investment management and caused many in the business to pursue the wrong strategies. In the same package, Ben Inker, co-head of asset allocation for the firm, explains the firm’s new forecasting package for stocks and why it anticipates that stock returns for the next seven years will be negative.

It has also been suggested that Fama’s work led to indexing. Not really. When we offered indexing at Batterymarch in 1971 we did so because we knew it was a zero-sum game. That for us was a complete and sufficient reason for indexing: active managers summed to market returns less large fees and commissions while indexers summed to market returns less small fees. To prove our belief, we simultaneously ran an active portfolio that ended its first eight years – a random number selected to coincide with my stay there – up 7% a year relative to the S&P. Batterymarch more or less shared the indexing business in its first few years with Wells Fargo, with the considerable propaganda skills of Dean LeBaron, our senior partner, more or less offsetting their huge size. They however did talk about the market’s efficiency, which, particularly back then, only existed in the minds of a few professors and apparently one or two academically inclined Wells Fargoans. To nail home this point, Jack Bogle’s Vanguard Index Fund in 1975 was, like us, also emphatically based on the concept of a zero-sum game and the certainty it offered that most players would underperform.