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By Scott Burns | 06-20-2014 02:00 PM

Asness: Splitting the Middle on Market Efficiency

Markets are very good with long-term price accuracy, but they are neither perfectly efficient, nor prone to regular bubbles, says the AQR founder.

Scott Burns: Are markets efficient? Hi there, I'm Scott Burns, Morningstar's global director of manager research, coming to you from the Morningstar Investment Conference. Joining me today is AQR's Cliff Asness. Cliff, thanks for joining us.

Cliff Asness: Thank you.

Burns: Now, recently the Nobel Committee handed out their prize for economics to Bob Shiller, Eugene Fama and a third person who you are going to bring up for me.

Asness: Lars Hansen.

Burns: Lars Hansen. Why does everybody forget Lars?

Asness: Because he is not fighting with the other two.

Burns: That's right. That's right. With the prize, you couldn't have two different camps. Bob is saying the markets aren't efficient; Eugene, of course, is on the efficient market [hypothesis]. You want to split the middle. How do we resolve this?

Asness: You've known me for a long time, and as I joked at the Conference, when I see a fire, I'm more often a gasoline thrower than a water thrower. I like to be in the extremes, if warranted. Here, actually I think the middle is the right place to be.

I think if you have one extreme that markets are very close to efficient, even Gene Fama will tell you they are not going to be perfectly efficient. He likes to shock the class by telling them that.

Burns: Does he know that you are telling people this? You know we're on camera.

Asness: He's said it in class for like 30 years, and he's written it. Gene, I'm revealing your secrets. Perfect efficiency as Gene would say is a very extreme hypothesis. But clearly, I think it's fair to say he thinks they are a lot closer than Bob does. Gene will not use the word bubble; Bob will use the word bubble a lot. There really are some big differences of where on the spectrum of "how efficient?" I think the Nobel Committee got it right because I think the efficient market hypothesis as created by Gene Fama was pretty much the most important contribution to modern financial economics. It is modern financial economics. We had no starting point. We had no, to be a geek for second, null hypothesis before Gene gave us one. We casually assumed markets were wildly inefficient. Index funds were un-American. Treasurers could issue stock or split stock or do anything. Obviously, they had great skill at doing that. Gene said, hey, wait a second, and he gave us his null hypothesis. 

I think if you go through time, my judgment of the evidence is both things academics love to study. They often call they anomalies; things that are hard to explain. Why cheap beats expensive; why good momentum beats bad momentum; why low risk seems to outperform high risk, especially when you take account for that risk, and other things. You get into both camps on these. There is the Fama efficient markets camp. I'm personifying with these two men maybe a bit too much, but let me call the Fama camp that will say, "These things work because it's risk." And the Shiller camp would say, "No, the market gets it wrong. These things work because the market makes errors."

When you step back, one thing complicated about the world and makes for very complicated model, is both can have a great degree of truth and which one is a more important factor can change through time. The real world can be much more complicated and kind of binary. One person is right, and the other is right. For instance, value investing, cheap beating expensive. I come out like I do on a lot of this, somewhere in the middle. I think both the risk stories and the inefficient-market-era stories have good logic to them, and the effect is really ridiculously strong when you add up all the evidence that we have of looking everywhere for all periods of time. It doesn't mean it's the same all the time. During, for instance, the period I'm kind of obsessed, the tech bubble, I think much of the difference in valuation was driven by irrationality. I think that was exception that maybe proves the rule, but I will use that world, bubble, about the tech bubble. I won't use it very often, putting me firmly in between.

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