Paper: Adaptive Market vs. Efficient Market Hypotheses

The adaptive markets hypothesis has gained a stronger footing in the financial world as the traditional paradigms of modern portfolio theory and the efficient markets hypothesis (EMH) have proven to be woefully inadequate, according a recent whitepaper by MIT professor Andrew Lo.

(April 4, 2012) — Many market participants are now questioning the broad framework in which their financial decisions are being made, asserts a newly released whitepaper by Andrew Lo, a professor at the MIT Sloan School of Management and chairman and chief investment strategist at AlphaSimplex Group.

The paper — titled “Adaptive Markets and the New World Order” — asserts that the traditional paradigms of modern portfolio theory and the efficient markets hypothesis seem woefully inadequate. “…but simply acknowledging that investor behavior may be irrational is cold comfort to individuals who must decide how to allocate their assets among increasingly erratic and uncertain investment alternatives,” writes Lo.

According to the paper, the efficient market hypothesis is not wrong, but incomplete. “Markets are well behaved most of the time, but like any other human invention, they are not infallible and they can break down from time to time for understandable and predictable reasons,” Lo writes, urging investors to view financial markets and institutions from the perspective of evolutionary biology rather than physics.

The paper questions, “Given these seismic economic shifts, is it any wonder that the dynamics of global financial asset prices, which must ultimately reflect the supply and demand of real assets, have become less stable in recent years?”

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The adaptive market hypothesis recognizes that human behavior translates to a complex combination of multiple deicision-making systems. “The behavioral biases that psychologists and behavioral economists have documented are simply adaptations that have been taken out of their evolutionary context: Fight-or flight is an extremely effective decision-making system in a street fight but is potentially disastrous in a financial crisis,” Lo writes.

Lo concludes by acknowledging that the adaptive market hypothesis is not nearly as developed as the efficient market hypothesis. The difference in popularity and development between the two approaches is changing, however, as more relevant data for measuring the evolutionary dynamics of financial markets and investor behavior across time and circumstances is collected.

Lo’s paper critiquing traditional paradigms of modern portfolio theory and the efficient markets hypothesis follows statements made last year by Saker Nusseibeh, the head of investments of Hermes and chairman of the new 300 Club, who said that institutional investors have gotten caught up in a risky world of irrational behavior, failing to look at the big picture. The 300 Club is mainly concerned about two areas, according to Hermes’ Nusseibeh. “First, we want a transparent debate about the theories of investment, which we feel are often misunderstood, misapplied, or plain wrong. People have forgotten where most theories come from,” he said, citing Harry Markowitz’ capital asset pricing model (CAPM) theory.

“At the base of Markowitz’ work, he talks about several assumptions you need to make in order to make the model work. The theory is sound. It’s a good idea, but we object to the way people have applied it. The result has been an increase in volatility,” said Nusseibeh, noting that the 300 Club aims to discuss the presumptions of financial theories, questioning their validity. “We question the efficient market hypothesis, the idea of alpha, and high returns with low risk. We just want to have a debate.”

Related article from aiCIO Magazine: An interview with Harry Markowitz, the grandfather of the modern portfolio theory.

(April 4, 2012) — Pension fund deficits on either side of the Atlantic are moving in opposite directions despite similar sponsoring employer efforts as economic forces take over, Mercer Investment Consulting has found.

The largest companies’ pension funds in the United States improved their funding ratios over the first quarter of the year, while their counterparts in the United Kingdom slumped in the time, the consultants reported today.

Mercer said in the US the aggregate deficit in pension plans sponsored by S&P 1500 companies fell to $336 billion at March 31, 2012, a decrease of $147 billion from the end of 2011. This meant the aggregate funding ratio improved from 75% to 82% over the three months.

Conversely, in the UK Mercer estimated the aggregate IAS19 measure of the FTSE350 pension schemes’ deficits stood at £81 billion at the end of March, up from £73 billion at the end of December. This represented a funding ratio drop from 87% to 86%.

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Both sets of companies had injected additional cash contributions totalling $20 billion and £20 billion respectively, in efforts to shore up deficits.

Mercer added that the deficit of pension funds of the largest 350 UK companies is £17 billion higher than a year ago. A boon of higher corporate bond yields, which reduced liabilities slightly, did nothing to offset the effect of market conditions hurting assets.

Adrian Hartshorn, Partner in Mercer’s Financial Strategy Group, said: “This highlights the potential downside of running a mismatched investment strategy. Even in this period of low interest rates there remain attractive opportunities for companies and trustees to reduce risk either through seeking some attractive investment opportunities or through managing the liabilities.”

In the US, the advice was the same for pension funds: to address the potential downside and manage liabilities through derisking.