The Ever More Efficient Market

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larryswedroe
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The Ever More Efficient Market

Post by larryswedroe » Mon Jun 06, 2016 7:26 am

http://www.etf.com/sections/index-investor-corner/swedroe-analysts-disappearing-edge

A new study shows how at least some anomalies become smaller, if not disappear, after publication, it's why markets are becoming ever more efficient, though they will never be perfectly efficient.

Larry

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nedsaid
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Re: The Ever More Efficient Market

Post by nedsaid » Mon Jun 06, 2016 7:36 am

Again we see what happens when everything speeds up. The news is faster, the trading is faster, the computers are faster. We also see what happens when more very bright people get into the investment business. You have very bright people coupled with computers cranking away 24-7 and rocks can get turned over at increasing rates. It is getting very hard to find mispricings in the market.
A fool and his money are good for business.

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Re: The Ever More Efficient Market

Post by larryswedroe » Mon Jun 06, 2016 12:01 pm

nedsaid
that's the theme in my Incredible Shrinking Alpha, the competition is getting much tougher. And that leads to the paradox of skill
Larry

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Rick Ferri
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Re: The Ever More Efficient Market

Post by Rick Ferri » Mon Jun 06, 2016 12:15 pm

When an anomaly becomes known and an increase in market participation causes the premium to disappears, it's called something. There must be a name for this "crowding out". I just don't know what it is. Does anyone?

Rick Ferri
The views expressed by Rick Ferri are strictly his own as a private investor and author and do not reflect the views of any entity or other persons.

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Re: The Ever More Efficient Market

Post by qwertyjazz » Mon Jun 06, 2016 12:29 pm

Convergence trading?

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Taylor Larimore
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Re: The Ever More Efficient Market

Post by Taylor Larimore » Mon Jun 06, 2016 12:30 pm

Rick Ferri wrote:When an anomaly becomes known and an increase in market participation causes the premium to disappears, it's called something. There must be a name for this "crowding out". I just don't know what it is. Does anyone?

Rick Ferri

Rick:

I believe it is called "self-destruct."

Best wishes.
Taylor
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Re: The Ever More Efficient Market

Post by MIpreRetirey » Mon Jun 06, 2016 12:41 pm

I'm guessing "crowding out" is most specifically used in:

What is the 'Crowding Out Effect'

The crowding out effect is an economic theory stipulating that rises in public sector spending drive down or even eliminate private sector spending. Though the “crowding out effect” is a general term, it is often used in reference to the stifling of private spending in areas where government purchasing is high.

http://www.investopedia.com/terms/c/crowdingouteffect.asp

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Re: The Ever More Efficient Market

Post by qwertyjazz » Mon Jun 06, 2016 12:48 pm

Theoretical models of arbitrage sometimes have liquidity, capital, performance based issues but I am not sure of size issues - if no size issues per person then one person could increase their action to the size of the anomaly - the inherent model here is that each trader wants to limit his exposure to their belief in the anomaly do it only goes away if enough of them act vs one who borrows a lot - you then get an old school Schelling diagram of the benefit decreasing and then reversing

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Re: The Ever More Efficient Market

Post by azanon » Mon Jun 06, 2016 12:50 pm

Rick Ferri wrote:When an anomaly becomes known and an increase in market participation causes the premium to disappears, it's called something. There must be a name for this "crowding out". I just don't know what it is. Does anyone?

Rick Ferri


William Bernstein had some really long word for it in a couple of his books, ... i forget what it was though, think it started with a D?

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Re: The Ever More Efficient Market

Post by larryswedroe » Mon Jun 06, 2016 2:15 pm

FWIW, crowded trades is the term you hear, but many anomalies persist WELL AFTER pubication, especially if they involve expensive to trade and hard to short stocks----with most of the anomaly being on the short side in some cases.
Larry

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Re: The Ever More Efficient Market

Post by saltycaper » Mon Jun 06, 2016 2:45 pm

Interesting article. Further advances in computerization certainly increased the speed at which market participants can engage in arbitrage and "vacuum up the pennies." They are very good at that. Indeed, they excel at determining the "correct" price down to the last decimal place. "No, the value of security x is not $15.284, it is $15.285." Unfortunately, sometimes the correct price turns out to be $100, or $0, and it is revealed just how awfully inefficient the market can be, and how it really does not always price in all publicly available information. I once heard an interview with either Fama or French after the financial crisis, where I think they were asked about how the market got the pricing of credit default swaps so incredibly wrong. The essence of their response: "I have no idea."
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

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galeno
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Re: The Ever More Efficient Market

Post by galeno » Mon Jun 06, 2016 3:11 pm

This is why I think "factor investing" is a load of crap. Whenever there is a "factor premium" it gets arbitrage away.

Rick Ferri wrote:When an anomaly becomes known and an increase in market participation causes the premium to disappears, it's called something. There must be a name for this "crowding out". I just don't know what it is. Does anyone?

Rick Ferri
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 3.0%. TER = 0.4%. Port Yield = 2.0%. Term = 35 yr. FI Duration = 6.2 yr. Portfolio survival probability = 100%.

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Re: The Ever More Efficient Market

Post by qwertyjazz » Mon Jun 06, 2016 3:21 pm

Galeno - probably not fully
http://scholar.harvard.edu/files/shleif ... itrage.pdf
The problem is not whether they exist - it is whether they are actionable - that is Fama and French work is important in theory at a minimum

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Re: The Ever More Efficient Market

Post by larryswedroe » Mon Jun 06, 2016 3:52 pm

galerno
Sorry but IMO you are throwing the proverbial baby out with the bathwater. IN the literature there are about 600 factors, or more. But only a small number, like maybe 10 at the most can pass the tests of being persistent, pervasive, robust to various definitions, implementable, and have logical explanations. And all of them have been well published and the premiums survive, though shrunk to some degree. But that is no different for the first factor of beta.
My new book will walk through which of the factors investors should focus on and why, providing the historical evidence and the academic research.
Note that of course some of the factors are clearly risk premium, like size and beta, and to a good degree IMO value too, and you cannot arb away risk.
larry

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Epsilon Delta
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Re: The Ever More Efficient Market

Post by Epsilon Delta » Mon Jun 06, 2016 4:33 pm

saltycaper wrote:I once heard an interview with either Fama or French after the financial crisis, where I think they were asked about how the market got the pricing of credit default swaps so incredibly wrong. The essence of their response: "I have no idea."

Having no idea why the market got it wrong is consistent with an efficient market. It's people knowing why it is wrong that calls the efficient market hypothesis into question.

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Re: The Ever More Efficient Market

Post by saltycaper » Mon Jun 06, 2016 4:41 pm

Epsilon Delta wrote:
saltycaper wrote:I once heard an interview with either Fama or French after the financial crisis, where I think they were asked about how the market got the pricing of credit default swaps so incredibly wrong. The essence of their response: "I have no idea."

Having no idea why the market got it wrong is consistent with an efficient market. It's people knowing why it is wrong that calls the efficient market hypothesis into question.


That's some twisted logic there. Yes... if people know something is wrong and the price is not corrected, that would call it into question, but this was after the fact, a comment about how the pricing was not correct in the past, and it continued to be incorrect until it blew up in people's faces. There is no definition of an "efficient market" that is actually useful if that scenario == market efficiency.
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

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Re: The Ever More Efficient Market

Post by vitaflo » Mon Jun 06, 2016 4:45 pm

Rick Ferri wrote:When an anomaly becomes known and an increase in market participation causes the premium to disappears, it's called something. There must be a name for this "crowding out". I just don't know what it is. Does anyone?

Rick Ferri


In gaming there's something called a Skill Cap, a threshold where more skill doesn't equal any extra results. The threshold can change as new strategies are discovered but eventually it settles on a cap after all strategies are found. After this it changes to "Meta" where you use the strategy that is directly counter to the most popular strategy to eek out any advantage, even though all strategies are known and accounted for. Eventually that strategy becomes the dominant one and the Meta changes again.

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Re: The Ever More Efficient Market

Post by saltycaper » Mon Jun 06, 2016 4:47 pm

saltycaper wrote:
Epsilon Delta wrote:
saltycaper wrote:I once heard an interview with either Fama or French after the financial crisis, where I think they were asked about how the market got the pricing of credit default swaps so incredibly wrong. The essence of their response: "I have no idea."

Having no idea why the market got it wrong is consistent with an efficient market. It's people knowing why it is wrong that calls the efficient market hypothesis into question.


That's some twisted logic there. Yes... if people know something is wrong and the price is not corrected, that would call it into question, but this was after the fact, a comment about how the pricing was not correct in the past, and it continued to be incorrect until it blew up in people's faces. There is no definition of an "efficient market" that is actually useful if that scenario == market efficiency.


To make this clearer, you have a (relative) non-market-participant commenting on how market participants seemingly had information to price the securities correctly, but for some reason did not. It's not the market participants that have no idea, it's the non-market-participant commenting on the market participants.
"I guess I should warn you, if I turn out to be particularly clear, you've probably misunderstood what I've said." --Alan Greenspan

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Re: The Ever More Efficient Market

Post by jrbdmb » Mon Jun 06, 2016 4:51 pm

Perhaps it is becoming more difficult to find inefficiently priced individual stocks, but it would be hard to argue (esp. considering the whipsaws of the S&P 500 over the past year) that the market *as a whole* is always priced rationally. I don't think there have been any fundamental changes in the US economy over the past year to justify a record high in the market, a drop that came close to an official bear market, and then a rebound back close to the record high.

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Re: The Ever More Efficient Market

Post by alex_686 » Mon Jun 06, 2016 4:53 pm

Rick Ferri wrote:When an anomaly becomes known and an increase in market participation causes the premium to disappears, it's called something. There must be a name for this "crowding out". I just don't know what it is.


I think the phrase you are looking for is "public exploitable arbitrage opportunity".

It has to be public. It has to be known. It can't be somebody's secret sauce or else they would let the exploit remain and take the cream off of the top.

It has to be exploitable, in 2 senses of the word.

The first is execution. Just because you see a flaw in the real world in your spreadsheets does not mean you can actually do the trade in the real world. This is a moving goal posts thanks to computers and wonks

The second lays in risk and return. In this case we are not talking about true arbitrage as in a riskless trade. One example is the January effect, Which is still there but very weak - probably the risk is not wroth the reward. Value and Small cap premium are another 2 examples. Exploiting that inefficiency can take up to 10 years. Consider the fading premium I think the market is "arbitraging" the premiums away efficiently.

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Re: The Ever More Efficient Market

Post by galeno » Mon Jun 06, 2016 5:07 pm

We (wife and I) became Bogleheads in 2006. IMO, the most important "factors", by far,are simplicity and portfolio cost minimization. Thus we hold a 2 ETF portfolio of 60% VWRD (VT) + 35% IUAG (AGG) + 5% CASH. Time is also an important "factor". Our port can be managed spending <10 min per year.

The 11 years before that, we used 5 factors and a concentrated (8-16 stocks + MMF) 80/20 portfolio. After all portfolio expenses, we beat the gross SP500 CAGR by 6%. The GSD required, the time spent on portfolio management, and years 2000-2002 were extremely stressful.

Before I became a Boglehead I thought I was an exceptional investor. Now I realize that beating the SP500 like we did was due to taking extreme risk and great LUCK.

If you wish to try to "beat the market", the formula is: factors + a concentrated stock portfolio + knowing when to sell + minimal trading.

The 5 "factors" we used were: 1. Mkt cap > $500M. 2. Good financials. 3. High profit margin. 4. Low PE. 5. Momentum.
AA = 40/55/5. Expected CAGR = 3.8%. GSD (5y) = 6.2%. USD inflation (10 y) = 1.8%. AWR = 3.0%. TER = 0.4%. Port Yield = 2.0%. Term = 35 yr. FI Duration = 6.2 yr. Portfolio survival probability = 100%.

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Re: The Ever More Efficient Market

Post by qwertyjazz » Mon Jun 06, 2016 5:24 pm

Alex686 I disagree
You only need one arbitrage to remove it - if they either get fabiusly wealthy continuously exploiting it or can have an infinite access to capital to exploit the anomaly
This model requires a limit in the size of arbitrage professionals and a slow but not instantaneous pick up in use of technique
Sort of like Rogers described in Diffusion of innovations IMHO
Please correct my logic as this is not my field

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Re: The Ever More Efficient Market

Post by Epsilon Delta » Mon Jun 06, 2016 5:46 pm

jrbdmb wrote:Perhaps it is becoming more difficult to find inefficiently priced individual stocks, but it would be hard to argue (esp. considering the whipsaws of the S&P 500 over the past year) that the market *as a whole* is always priced rationally. I don't think there have been any fundamental changes in the US economy over the past year to justify a record high in the market, a drop that came close to an official bear market, and then a rebound back close to the record high.

Efficient does not mean rational. It means unpredictable. Those price movements are entirely consistent with an efficient market. To prove the market isn't efficient you need people who predicted the movements. It helps if they used those predictions to make oodles of money, and not just by luck*.

* Ruling out luck is tricky.

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Re: The Ever More Efficient Market

Post by HomoLudens » Mon Jun 06, 2016 8:35 pm

alex_686 wrote:
I think the phrase you are looking for is "public exploitable arbitrage opportunity".

It has to be public. It has to be known. It can't be somebody's secret sauce or else they would let the exploit remain and take the cream off of the top.



I don't want to split hairs, but I think it's trickier than that. "Public" can mean at least two things. First, each participant knows a certain fact ( X exists), but she doesn't what others know. This is mutual knowledge. Second, each participant knows a certain fact and she knows that the others know the same fact. This is common knowledge.The knowledge of the fact is the least common denominator, but the behavior of the market participants varies depending on their perceptions about what other people know. After all, people are strategic. That's why I have problems with the definition of "public" because it conflates these two situations. Not to mention the fact the market often reacts on the basis of rumors and market participants assign different degrees of belief to these pieces of information. There are different verification procedures in place in order to attain certain knowledge. And these procedures have to replicable ( " I have a gut feeling" doesn't count in theory, but it's often used as a valid justification in practice). Thus, being "public" and being "known" are just convenient idealizations, yet they are often quoted as axioms.
"'Thoughts without content are empty, intuitions without concepts are blind." Immanuel Kant

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