Less efficient markets call for active management, says CFA

Is it possible to beat the market?

No, posits the efficient market hypothesis (EMH), because share prices already incorporate all relevant information.

In such a perfectly efficient scenario, the more risk you assume, the greater your return. In reality, though, markets aren’t perfectly efficient (though you’re sure to find research in support of either side of the EMH debate).

Two sources of inefficiency are market structure and investor behaviour, as explained in a market ethos report by Chris Kerlow, a CFA with Richardson GMP. And the level of inefficiency determines whether a passive or active approach is best.

Market structure and investor behaviour

Market frictions, such as transaction costs and information availability, limit market efficiency. Real estate, for instance, has high transaction costs compared to large-cap equities, and the information to make real estate investment decisions isn’t as easily obtained.

Comparing Canadian equities, the report says smaller-cap funds have fewer investors, less analyst coverage and likely higher borrowing costs for shorting compared to large caps, making them fertile ground for active management.

In fact, evidence shows actively managed funds in the small- and mid-cap categories outperform their benchmarks compared to actively managed large-cap funds (about 57% to about 23%, using SPIVA data).

Read: Critiquing a case for active management

A similar comparison can be made between the Canadian and U.S. equity markets, with the latter being more efficient because it has more investors, greater liquidity and more diversification.

Adding to inefficiency is investor behaviour. With behavioural finance a growing academic pursuit, it’s no surprise that investors suffer from cognitive mistakes. The report puts the spotlight on Valeant, saying it’s hard to argue the market is efficient when Valeant shares were priced at $35o in 2015 and at $15 today.

Read: Win the wealthy clients of the future

Bottom line: go for active investment strategies to get an edge in less efficient markets and passive strategies in more efficient markets. Read the full report.

Also read: Interested in leveraged strategies? Be cautious

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.