Posted by Fundmentals on November 06, 2009 at 11:29:11:
(Note: The relevance of this link to this forum comes from the not infrequent use of market efficiency to make assertions that actively managed funds cannot possibly beat indexed funds. And the use of Fama's framework based on his assumptions to evaluate the performance of funds by M*, S&P, etc.
The purpose of this is post is to be aware of the basis for such evaluation given the controversy surrounding the assumptions.)
The EMH proponents have been under attack since the financial meltdown and this recent column from Prof. Fama on his own web site is prompted by a recent book in that vein from Justin Fox titled "The Myth of the Rational Market" (which is actually a very good book).
Prof Fama appears to be understandably defensive in this column. (As a side note, it is a bit unusual to see an academic claim as a conclusion "I won" concerning his theory).
However, one has to wonder whether the good Professor is entirely out of touch with reality or as he claims Justin Fox's book is a fantasy. Consider the following statement:
"The recent problems of commercial and investment banks trace mostly to their trading desks and their proprietary portfolios, and these are always built on the assumption that markets are inefficient. Indeed, if banks and investment banks took market efficiency more seriously, they might have avoided lots of their recent problems."
Both facts and logic would make this assertion invalid.
In reality, the proprietary trading desks of these banks have ALWAYS been profitable, through last year AND this year. I am not sure what he means by proprietary portfolios. They buy, sell and hold all kinds of securities including asset backed securities.
The problems with banks came by holding real estate asset backed securities which by themselves may not have been such a serious problem (they are just one component of a bank's total assets and their value can go up or down in their models) if there wasn't a confluence of events that also froze inter-banking credit at the same time they were also highly leveraged.
Like a plane accident that is caused by a number or contributory and independent causes each of which by itself may not have caused the accident.
This meant all of their operations were affected not just the asset-backed securitization and they didn't have enough cash buffer to ride it out from a balance sheet perspective. It wasn't as simple as a model assuming that property values will not go down as portrayed in the pop media which might make it amenable to discussions of market efficiency or inefficiency. There have been enough postmortems of the crisis to document these.
What both proponents and antagonists of EMH seem to be missing is the possibility that EMH is too simplistic a hypothesis to reflect reality that rather than the false dichotomy of assuming it either hurt or it would have helped, there is a third possibility that the hypothesis (as opposed to concepts of efficiency or inefficiency) itself is irrelevant to the workings of the market. In other words, it neither hurts nor helps, it just doesn't contribute/affect in any way.
From that perspective, Fama's assertion that if banks and investment banks had paid heed to market efficiency, they might have avoided some of the recent problems is a bit self-serving with no way to justify it but is also a logically fallacy. Even if you assume as correct Not X caused Y, then it does not logically follow that X will cause Not Y.
I doubt very much that Prof. Fama will ever receive the Nobel Prize in Economics even though his name keeps coming up every year in the list of contenders.
Without market inefficiency and without people being rewarded to exploit that inefficiency, the markets would no longer have prices that reflected fundamentals in any way.