Saturday, September 19, 2015

Is the EMH research project dead?


Brad DeLong:
[I]t is, I think, worth stepping back to recognize how very little is left of the original efficient market hypothesis project, and how far the finance community has drifted--nay, galloped--away from it, all the while claiming that it has not done so... 
The original EMH claim was...[y]ou can expect to earn higher average returns [than the market], but only by taking on unwarranted systematic risks that place you at a lower expected utility... 
[But f]inance today has given up any preference that the--widely fluctuating over time--expected systematic risk premium has anything to do with [risk]...It is very, very possible for the average person to beat the market in a utility sense and quite probably in a money sense by [buying portfolios of systematically mispriced assets].
DeLong cites the interesting new paper "Mispricing Factors", by Robert Stambaugh and Yu Yuan. The paper puts sentiment-based mispricing into the form of a traditional factor model.

Is DeLong right? Is the Efficient Markets research project dead?

Well, no. Models that explain time-varying risk premia (really, time-varying excess returns) as the result of time-varying utility are far from dead. The finance academia community doesn't use these models exclusively, but they are still very common. Probably the most popular of these is the "long-run risks" model of Bansal and Yaron (2004), which relies on Epstein-Zin preferences to produce time-varying risk aversion. As far as I am aware, lots of people in finance academia still consider this to be the best explanation for "excess volatility" (the time-series part of the EMH anomalies literature). In a different paper from around the same time, Bansal et al. claim that this approach can also explain the cross-section of expected returns.

(Note: As Brad mentions in the comments, Epstein-Zin preferences are different from Von Neumann-Morganstern expected utility. It represents a departure from the standard model of risk preferences, but not from the core idea of the risk-return tradeoff.)

So the idea of explaining asset returns with funky risk preferences is not dead by any means. But this literature does seem to have diverged a bit from the literature on factor models.

As soon as multifactor models like Fama-French started coming out, people pointed out that they weren't microfounded in economic behavior. There was no concrete reason to think that size and value should be associated with higher risk to the marginal investor. EMH-leaning supporters of the models - like Fama himself - waved their hands and suggested that these factors might be connected to the business cycle, and thus possibly to risk preferences. But in the end, it didn't really matter. The models seemed to work - they fit the data, so practitioners started using them.

But since factor models aren't explicitly connected to preferences, there's no reason not to simply treat apparent mispricings as factors in a factor model. Really, the first example of this was "momentum factors". But the new Stambaugh and Yuan paper takes this approach further. From their abstract:
A four-factor model with two "mispricing" factors, in addition to market and size factors, accommodates a large set of anomalies better than notable four- and five-factor alternative models...The mispricing factors aggregate information across 11 prominent anomalies...Investor sentiment predicts the mispricing factors...consistent with a mispricing interpretation and the asymmetry in ease of buying versus shorting. Replacing book-to-market with a single composite mispricing factor produces a better-performing three-factor model.
Stambaugh and Yuan take the "mispricing factors" approach further than in the past, by looking at limits to arbitrage and at investor sentiment. Limits to arbitrage and investor sentimennt are microfoundations - they are an explanation of mispricing factors in terms of deeper things in the financial markets. In other words, Stambaugh and Yuan aren't just fitting curves, as the momentum factor people were. This is behavioral finance in action.

Now this doesn't mean that the EMH research project is dead. First of all,  Stambaugh and Yuan still have to compete with papers by Bansal and other people working on the EMH research project. Second of all, increased attention to the "mispricing factors", or decreases in the institutional limits to arbitrage, may make them go away in the future. Third, risk-preference-based factors may still coexist with mispricing factors. And fourth, even if the mispricing factors are robust, the EMH is still a great jumping-off-point for thinking about financial markets.

So I think the rise of mispricing factors doesn't really signal the death of the EMH research project. What I think it signals is that finance researchers as a group are open-minded and eclectic, unwilling to restrict themselves to a single paradigm. Which I think is a good thing, and something econ people could stand to learn from...

31 comments:

  1. I would ask you to clarify: By "funky risk preferences" you mean "people who, if their attitude to household risks were analogous to their attitude toward equity risks, would be afraid to step into the bathtub for fear they would slip on the soap and break their neck".

    Brad

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    1. I think Epstein-Zin is more analogous to not getting a bathtub because it would increase the long-run risk of slipping on the soap and breaking your neck.

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    2. Just as long as you acknowledge that Epstein-Zin starts from von Neumann-Morgenstern, and takes a giant step *away* from the paradigm of rational decision-making under uncertainty...

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    3. Roger has a nice post on the subject: http://rogerfarmerblog.blogspot.com/2015/07/behavioural-economics-and-exotic.html

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    4. Roger spells "behavioral" like a Brit! Speak Amurican, Roger, none o' this "English" stuff!!

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    5. And yes, the notion that there's a deep fundamental difference between "behavioral" and "rational" behavior rules is more than a bit silly. Not just for the reasons Roger says, but also regarding the "faulty information processing" wing of behaviorism. What looks faulty to us is probably optimal under some set of constraints - see Gabaix's work on sparse information processing, etc.

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  2. The EMH should have been dead at least since Keynes' "Beauty Contest," but...

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    1. Logical arguments don't kill hypotheses, only data kills hypotheses! ;-)

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    2. The great tragedy of science - the slaying of a beautiful hypothesis by an ugly fact.

      Thomas Huxley

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    3. No, beauty contests, even if true, don't refute the EMH. And logical arguments can kill hypotheses, but require actual logic.

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  3. If I assume that the investors around me are irrational and that government and its agencies are incompetent, malevolent or both what am I as a poor little investor to do?

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  4. The new paper is just data mining. Some behavioral regularity explains the return pattern? Given how many different behavioral anomalies have been identified, there's no doubt some of them will fit.


    Unless, the specific anomaly produces robust insights in other situations, it's just garbage.

    I know you guys get paid to talk, but you should ask yourself the question: if in Psychology, two thirds of studies are noise, what do you think the percentage is in finance? 70%? 80%? 90%?

    Any stuff you see, you should greet with a question: Why should I think the particular study is NOT noise.

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    1. Sure, but the same few anomalies keep popping up everywhere, and this just puts them in a slightly different form. It's not really a brand new discovery.

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    3. Anonymous9:36 PM

      When everyone is looking at the same timeseries, the fact that the "same few few anomalies" keep popping up is not quite so impressive. Wake me when you find a secret cache in the CRSP basement with an independent dataset from Bizarro World that displays precisely the same anomalies :-)

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    4. Haha fair enough. But they find basically the same stuff in overseas markets too.

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  5. Hi Noah: I don't know of anyone who finds a true anomaly and is naive enough to publicize it. I'm a statistician rather than an economist but I do a lot of econometrics that I would never mention the details of. I know of no one who has truly fund a statistical-econometric anomaly that makes consistent profits who would tell others about it ? So, when you say that they're well know and keep "popping up", what are you referring to ? A lot of people would love to know. Thanks.

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    1. You brag once it goes away. In truth, if it's something systematic and large, things slowly leak out and become common knowledge in the industry. You can't work alone.

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  6. From what I hear the current practitioner (no talk about it) mode is for the intermediate run to play the anomalies. Find them and put them in with a rapid decline in the trading algorithm ahead of the other traders. Shorter time horizons become econophysics, and the really long run time horizon remains being dead as one randomly walks, however that is done after one pays off the relatives of those dying as one throws those darts without thinking...

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    1. No, actually that's not what happens. Majority of so called anomalies (or inefficiencies), no matter how thoroughly back tested, just fall apart very quickly the moment you start trading them. It has little to do with others catching on. It turns out majority of stuff is noise. Information is hard to get.

      It's a bit different for high frequency microstructure plays. There, things are not as ugly. Just more competitive.

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  7. If anything, I think the markets have gotten more efficient as evidence by the post-2008 poor performance of active management. Funds are finding it increasing difficult to beat the S&P 500 benchmark.

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  8. Brad's thinking on this is simply soft, and an example of why I don't read him. He dislikes EMH because some people interpret it politically conservatively, but fails to grasp what it really means. It doesn't say that no systematic mispricing can exist;it says that none can exist and be generally known. As such it's logically impossible for a discovery of a previously not generally known systematic mispricing to disprove EMH.

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  9. I've worked in prop and hedge funds and I disagree with the idea the short term strategies ( non HFT but short term ) go away quickly. I know that some short term strategies can withstand the test of time if the knowledge of them is not easily obtained.

    Millenium and Rentech's returns are real and the people that run them often do run them alone. Or, if they have developers in the group, the developers are not necessarily given access to the strategies. The quant strategies at these places work and are kept SECRET as much as it is possible to keep them SECRET.

    I'm referring to strategies that intuitively would go away by too many people knowing ( Maybe there are some that thrive on a lot of public knowledge but I don't know of them ) which is why they are kept so secret. But my point was that Noah made it sound like these pop up in the public all the time. I don't think they do. It's an incredibly competitive, dog eat dog and secretive business.


















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    1. Yes, Renntech did great in their main fund: the very short term one, but then Simmons decided to do something on a bit longer time scale. How well did that go?

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  10. Hi Kryz: I don't know. All I know is that Rentech and Millenium do well enough to
    imply that there are strategies out there that withstand the test of time and don't go
    away because too many people know about them.

    As we all know, the devil is in the details. For example, everyone knows that specific stock behavior occurs during the day ( atleast usually ). But how does one exploit that ? That's what matters. Probably similar concepts for other strategies.

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    1. Rentech's workhorse is the Millenium fund, which is very short term, essentially HFT. That's a mircostructure play. Lot's of data, relative stable behavior, processing power counts for a lot. That's not the case, the moment you start going on longer time scales. Rentech found that out, when they did try to go a bit longer.

      I am not saying there are no patterns to be exploited, but they are not easy to find. That actually has little to do with competition or even its generalization: EHM. Noise rules in small samples.

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  11. >> It doesn't say that no systematic mispricing can exist;it says that none can exist and be generally known. As such it's logically impossible for a discovery of a previously not generally known systematic mispricing to disprove EMH. <<

    "mispricing" means, in practice, that there will be a correction. Corrections today mean there was mispricing in the recent past.
    EMH says there is no generally known way to see mispricing today, before the correction in the near future.
    If there was a way, investors would anticipate the future correction and buy/sell now -- which would eliminate the mispricing and cause a smaller correction sooner.

    Grey's EMH Lemma - any "economic law" or insight that allows investors to consistently make more money than a random walk will lead investors to change their investment behavior in such a way as to invalidate that previously valid insight.

    "US House prices always go up" (pretty good from 1982-2006, but then!) is just one example of such a policy.

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  12. Tom: That's exactly what I'm saying. Some mispricings exist and continue to withstand the test of time because they're not widely ( or atleast not widely enough ) known.

    The reason this all got brought up was because Noah made it sound though like these things "pop up all the time" and are well known which I don't agree with.

    To me, the term "mispricing" and "pattern" are sort of synonymous in this context.
    Although I think it's more clear if EMH said that that patterns can exist only when they are not widely known.


    The term "mispricing", to me, implies that it's going to correct at some future point and, in some cases, it clearly doesn't ( atleast in the offices of Millenium, Rentech etc ). But I agree with you that the term "mispricing" is used in the literature rather than the term "pattern".

    Actually, now that I read your response again: I think Grey's EMH Lemma says
    it best: Any "economic law" or "insight" which are both very similar to "pattern". Thanks.






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  13. Noah, in your last bloomberg view article you affirm that capital taxes are the most distortionary ones. Of course, I do not want to question that they are, but you should read this paper http://www.nber.org/papers/w20441, which shows that the famous Chamley-Judd result simply comes out of a mathematical error.

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  14. I don't understand vey much about your interesting argument, but EMH has been refuted by the financial facts between 2000 (bubble) 2008 (burst) and the following up. It is ridiculous the pretence of these guys of not to recognize their troubles. EMH doesn't work, because is impossible. It doesn't fit the facts and never will fit them.

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