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I Really Want to Crush the Efficient Market Hypothesis….

This is my OCD speaking again and I’m not gonna beat around the bush here.  I have a big problem that I need to solve in the coming decade.  You see, Eugene Fama has sparked a bit of an investing revolution by convincing the world that the Efficient Market Hypothesis and “passive investing” are sound approaches to the world.  As a macro monetary theorist who rejects most things out of the Chicago School of Economics due to its highly politicized views, I have a big problem with these ideas because I think that the same sort of politicization in the macro econ work has filtered over into the finance work.  It’s very cleverly marketed, but largely based on the same erroneous underlying positions like “rational expectations” and whatnot.  Anyhow….

Barry Ritholtz posted a link to a video called “Winning the Loser’s Game” on Twitter (you can watch part 1 here and part 2 here).  The conclusion is something that’s becoming very popular these days – the idea that, in investing, you can’t go wrong with a low cost passive indexing approach.  It’s true to some degree.  The less active you are the more you’ll reduce frictions like tax inefficiencies and costs.  But the very foundation of the idea of “passive indexing” is based on a misunderstanding of the way markets function at their macro level.  In fact, passive indexing is, by definition, portfolio construction resulting not only in active asset picking, but active asset chasing.  Let me explain.

As I’ve explained previously, there is no such thing as a truly passive portfolio.  That is, the only “passive” approach would be buying all of the world’s financial assets and simply taking the market return it generates every year.  Of course, you can’t do this because no such product allows you to do this as William Sharpe has stated:

“I would like to see a very-low-cost index fund that buys proportionate shares of all the traded stocks and bonds in the world. Unfortunately, there are none at present.”

Sharpe is right.  The only truly passive index is a portfolio of the global financial assets.  And since no such portfolio exists in any realistically applicable manner, you must, by definition, actively choose to pick your assets in some way.

What’s interesting about the Global Financial Asset Portfolio (GFAP) is that it’s basically a 55% bonds and 45% stock portfolio at present – an allocation that runs counterintuitive to the way most of us are taught to allocate assets with a stock heavy “buy and hold” methodology.  Most of us actively choose to reallocate the GFAP into something else which, as Cliff Asness has clearly stated, is nothing more than an active management decision often cloaked by another “passive” name:

“You can believe your strategy works because you’re taking extra risk or because others make mistakes, but if it deviates from cap weighting, you don’t get to call it “passive” and, in turn, disparage “active” investing. This peeve may be about form over substance—marketing versus reality—but these things count.”  – “My Top 10 Peeves” by Clifford S. Asness

What’s most interesting about these videos and the “passive investing” approach is that its grounded in the idea of Eugene Fama’s Efficient Market Hypothesis, a theory with faulty underlying foundations and several internal inconsistencies.  The most glaring internal inconsistency is the very terminology itself and its advocacy to “passive” investing based on the idea that the markets are smarter than the rest of us.  Eugene Fama, who popularized the EMH, did not seem to understand that, at the macro level, the current snapshot of global financial assets is an ex-post view of how inefficient markets are currently allocated.  That is, it is a largely reactive allocation to macro trends.  More importantly, the GFAP is a dynamic portfolio that changes over the course of its lifetime to account for changes in macro trends.

For instance, in the 70’s & 80’s the GFAP was equity market heavy while the current GFAP is bond heavy.  When one accounts for the risk adjusted returns this portfolio has proven to be positioned entirely incorrectly for decades at a time as it adjusts to changing macro trends.  The investor who was bond heavy in 1980’s substantially outperformed the equity heavy portfolio on a risk adjusted basis while only slightly underperforming on a nominal basis.  In other words, the markets and the GFAP did not produce the most optimal outcome for investors.

This is why investors who were bond heavy like Cliff Asness, Ray Dalio, Bill Gross are held on such high pedestals – they took a proactive view of the environment by accounting for the reality that bonds were undervalued relative to stocks.  Today, we’re at the nearly exact opposite environment yet the GFAP would tell you to be bond heavy 30 years after the optimal time to do so.  In other words, an indexing purist is chasing a trend at its worst possible time.  Therefore, the truly passive investor is simply chasing performance and very likely to generate sub-par returns in the coming decades.

What’s so fascinating about this view of the markets is that it’s been used to demonize any form of “active” investing without realizing that we are all making active decisions by deviating from the GFAP.  Worse, anyone who blindly follows the GFAP (as an indexing purist would) is simply relying on the ex-post snapshot of the markets without realizing that their returns rely largely on chasing macro trends that have already played out.

When someone tells you to invest “passively” in index funds they likely don’t understand three important facts:

1.  There is no such thing as “passive investing”.  Therefore, by definition, indexers are always advocating some form of active “asset picking”, but rationalizing this based on some other theoretical underpinning such as “factor tilts” or “risk tolerance” which are also known as excuses for active asset picking.

2.  They are engaging in a forecast of some type even though they often market themselves as “forecast free” investors.  This is due to the fact that any portfolio with a directional bias has an underlying dependence on the performance of the underlying macro economy to some degree.  An equity heavy portfolio relies on economic expansion whether you call that a “forecast” or not.

3.  A passive indexing purist is, by definition, a performance chaser since the GFAP allocation is nothing more than an ex-post snapshot of macro trends.  This portfolio, with certainty, will position you poorly at times during economic cycles and therefore requires an element of active reallocation.   Smart investors who reject nonsense like “rational expectations” will identity these periods and turn against the “wisdom of the crowd”.

Ironically, “passive” investors often demonize “active” management of any type without understanding that they themselves are almost always active.  Worse, a truly “passive” portfolio is nothing more than an ex-post snapshot of the way markets have responded to macro trends.  Therefore, these portfolios often result in the same type of portfolio chasing that “passive” indexers demonize investors for.    What, in the world is rational about being overweight bonds AFTER the greatest bond bull market in history?  But that’s exactly what an indexing purist would advocate today unless they applied Fama’s “factor tilts” or other theoretical excuses for active asset picking.

We have to be careful with this “passive” investing ideology.  Yes, you should be concerned about fees and frictions.  If you pay someone 1% a year for portfolio management then you’re likely overpaying for their services.  But at the end of the day indexers should know that asset allocation decisions are the primary driving factor in returns and almost all indexers are involved in a form of active “asset picking” that will drive their results.  And whether that asset picking is based on any underlying rational premise is highly debatable.  One thing I can assure you is that if it’s based on a rationale similar to the EMH then it’s probably got some glaring holes in it.


  1. Cowpoke

    Why the knock on passive investing? Isn’t that inline with your humans will continue to progress phlosophy?

    On a side note, I think we are regressing in a lot of ways. Take art for example Andrew Pollack? C’mon..

  2. Suvy

    Efficient markets is a bad way of looking at markets. Markets are just structures with different people working on different types of information across different timescales. Traders/speculators work on shorter time frames, but provide value by dissipating information and providing daily trading volume. Investors, on the other hand, work on longer time frames and work off the income generated by the asset over its lifetime.

    Markets get out of whack when longer term investors either drop out of the market completely or start behaving on short term information. In these scenarios, markets can exhibit completely unpredictable behaviors like bubbles and crashes. Bubbles can result from “rational” behavior if you assume the errors can be correlated (EMH assumes errors are uncorrelated and normally distributed). Certain economic, political, social, or geopolitical events can cause this king of behavior and so can massive liquidity expansions (ex. QE or extremely large deficits).

  3. anchord

    I doubt he is saying anything against his human progress/optimism, just clarifying some wording/definitions of what passive means.

    though, regression is on epic scale…the society(s) confused like never before.

  4. Suvy

    There’s a difference between progress and civilization. Just because you “progress” doesn’t mean you’ve become more civilized.

  5. Frederick

    I started watching video #1 on YouTube and noticed that the next video in their play list was titled “How can you insulate your portfolio against major market downturns?” where they interview some managers about how to actively pick funds so you can protect your portfolio from downside risks.


    Are these “passive” investors really so stupid that they don’t realize that picking their asset allocation involves a forecast and an active decision? These people are no different than stock pickers. They just don’t understand what they’re doing and seem to think that since they use index funds then they’re “indexers”.

  6. Frederick

    I don’t think Cullen has anything against low fee indexing. I think he has a problem with the idea that low fee indexing is a “passive” endeavor. And he’s 100% right. Most of the people implementing an indexing strategy are actively picking funds.

    Cullen is just being precise.

  7. Cullen Roche

    I am not knocking passive investing. How can you knock something that doesn’t exist? 🙂

    I am just pointing out that no one can actually mimic an index perfectly. And what most indexers do is actually an active form of asset picking using an index. That doesn’t make them “passive”. It makes them asset pickers. Fine. That’s great. Use an index. Use a low fee approach. Use a tax efficient approach. I am an advocate of all of that! But don’t go fooling yourself into thinking that what you’re doing is some sort of totally different approach than anyone who actively picks an asset class. Being less active than a day trading monkey doesn’t mean you’re “passive”. It just means you’re less active than the monkey….

    I think investors should go into the asset allocation process with their eyes wide open. If you’re allocating to a 60/40 or whatever you should know what the drivers of that portfolio are and what the probabilistic outcomes are. You should look into the future and try to understand what might drive the returns you think you’ll get rather than running some silly backtests, relying on ex-post snapshots of the world. reading some silly book on index fund investing and then deciding that because you’re using a low fee approach that that means you’re making a smart decision. That’s just naive.

  8. Conan

    It would be interesting to see how a portfolio that would always take the opposite weights of the GFAP (now 55 stocks, 45 bonds) would perform. Maybe rebalancing yearly or so. Kind of a global market portfolio contrarian strategy.

  9. Chalk bag

    Cullen, I mean no disrespect, but as an active investor, why would you want the competitors to be any smarter?

  10. MrFancipants

    This seems to be largely an argument in semantics. I have never considered a passive investment strategy to be the pure GFAP model. I always considered it to be an investment in index funds with very low expense ratios, low turnover, and tax efficient. So if by passive investing it is to mean only a pure GFAP, then I agree. However, to claim that use of some combination of low cost index funds is the equivalent of actively managed mutual funds is going too far in the other direction.

  11. Cullen Roche

    Semantics matter! In fact, I’d argue that the “passive” advocates are being sloppy precisely because they’re not looking closely enough at the details of the discussion.

    When one deviates from the GFAP they are making an active asset picking decision inside of the world aggregate. This is not much different than a stock picker who picks stocks inside a stock aggregate.

    Don’t get me wrong. Fees and all that are hugely important. But NOTHING will be more important to your returns than your allocation choices. And you have to realize that if you pick assets then you’re engaging in a very active endeavor. Embrace it. Understand what you’re doing. And don’t go thinking that just because you use index funds that you’re doing something that doesn’t require forecasting or trying to “beat the market”. You are, by definition, doing precisely that when you deviate from the GFAP.

  12. MrFancipants

    Yes, of course these are two distinct decision making steps: what is an appropriate asset allocation strategy vs. how to invest in those asset categories (passive or active). So how are they being confused?

    And I don’t agree that by choosing a certain asset allocation you are trying to “beat the market”, I think the main goal is to find a diverse portfolio that is risk-adjusted to the investors tolerances while still attempting to achieve investment goals.

  13. pliu412

    Basically EMH makes unrealistic assumptions about two parameters in forward-looking market behaviors:

    1. look ahead time = 0, i.e. immediately
    2. degree of price-in = 100%, i.e. completely.

    In reality, the values of these two parameters are time-dependent and various depending on both financial and non-financial information characteristics.

  14. Cullen Roche

    “The market” is the GFAP, by definition. If you are changing that allocation then you obviously think you are doing something that makes your allocation superior. In some way, you are convincing yourself that you’re “beating” it. If the GFAP were the portfolio that always generated the optimal risk adjusted returns because it’s so “efficient” and because the market is so much smarter than everyone else then you’d never deviate from the GFAP.

    Choosing to deviate from the GFAP is an active decision that claims you’re creating a portfolio that is more efficient for you than the GFAP is. That’s fine. I agree with it. But we should be very clear about what we’re doing. We’re making an active asset allocation decision inside of the aggregate GFAP and that active asset allocation involves forecasts and an active approach to portfolio management.

    Calling all of this “passive” is just a marketing ploy used by some firms who are trying to differentiate what they’re doing. But the reality is that picking assets inside an aggregate is not much different than picking stocks inside an aggregate. It’s just that picking indexes inside the global asset index happens to be a more efficient way of picking assets. But let’s call it what it is – asset picking and stop with the delusion that “passive” investing is something it’s not….

  15. MrFancipants

    Point taken and I totally agree with the distinction you are making. But this is also where the semantics comes in again, for me, in that my association with passive investing and the concept of “beating the market” refers primarily to equity investing. Yes there are bond and REIT indexes, but it is the very large equity mutual fund market that has been and continues to produce more underperfomers than overachievers. It is the actively managed mutual fund market that has helped to create a great argument for low cost indexing. It is also the poorly structured 401k system which forces those that are paying attention to the contrast between active and passive management. If they are paying attention, and so to your overall point, of increased awareness, I say YES! And also thanks for your part in increasing this enlightenment.

  16. Cullen Roche

    Yeah, I don’t mean to sound like am an anti indexing. I am 100% in favor of low cost indexing. I just think we should go into this endeavor with our eyes wide open. That is, we should understand that we’re making active bets and bets that are based on forecasts. None of us just take the market return. It’s about using a framework for portfolio construction based on a sound foundation as opposed to much of the MPT and EMH nonsense which I don’t think is very well grounded in realistic assumptions.

    But I totally agree – the vast majority of “active” managers are just closet indexers who are charging high fees for nothing special. And they deserve to go out of business. But that doesn’t mean we should all fire these terrible managers and then engage in something we have convinced ourselves is “passive”. No, we’re basically engaging in something that’s a more efficient version of asset picking than what many professionals do. And we’re saving the fees paid to these professionals by assuming that we can basically do it on our own. That’a great! I am all for that.

    But you should probably also recognize that you’re an asset picker who is relying on his/her ability to forecast the future returns of certain assets inside your portfolio. In my opinion, some people will do this more efficiently than others because they start from a more realistic foundation….In fact, I am pretty certain that I can point out highly inefficient “passive” approaches based not only on empirically based forecasting, but grounded in the realities of the way the capital structure generates returns.

  17. John Richards

    Mr Roche, your point is well taken, but to play a little devil’s advocate – a ‘passive’ investor is buying into a framework that has one main utilitarian function – it tends to work reasonably well. I actually agree with your arguments, but I think the classic school of thought gives people a simple place to start. 95% of the public won’t care about the things that you and the other 5% of us really do; they just need a decent framework to move forward with. You may be one of several voices that eventually pushes aside that framework, but you need something simple and workable to replace it, because otherwise it will just confuse the heck out of all the folks who haven’t a clue how to start. Everyone needs a point of reference, even if it’s flawed.

    BTW interesting book. It’s given me plenty of food for thought.

  18. Sean

    Asset prices are discounted expected future cash flows. The weightings of the GFAP reflect the aggregate view of all members of the investment community with respect to the magnitude/timing/variability of these cash flows.

    So I don’t think it’s fair to dismiss a passive approach as “return chasing”.

    A true passive investor would own the GFAP. He/she could either go try and replicate that portfolio his/herself by buying little pieces of each asset in the index. Or, much more realistically, he/she can outsource the task to an index fund manager. For this service, he/she will pay a very modest fee.

    That fee can be considered a convenience charge.

    (That last bit was directed to some comments you made on Twitter saying a passive approach was impossible to implement given the fees.)

  19. John Richards

    Mr Roche’s point is more clearly made in his book – the composition of Index funds tends to skew towards industries and companies that have done well recently, and so indexers become inadvertent ‘return chasers’ by virtue of simply holding the index. One could argue this is a weakness in Index construction, fine, but it’s near universal, The point is that Indexing is often mischaracterized because people don’t really understand how it works.

  20. LVG

    The discounting mechanism of the market is not always efficient though. If it were then why would the GFAP be so bond heavy in an environment where bonds are likely to generate very poor returns going forward? Or, as Cullen noted, why was the GFAP equity market heavy when bonds were so cheap relative to stocks in the 70s and 80s?

    Buying the GFAP assumes that the discounting mechanism of the markets is an efficient process. The evidence supporting that idea appears to be flimsy at best and completely wrong at worst.

  21. Sean

    Hey, if you can beat the market, then good for you and by all means, go for it!

    But the point of passive investing is that a naive investor (not as skilled as yourself) should not assume he/she has any edge and should instead seek to hold the market portfolio.

    And I’m not at all convinced by a counter-argument based on the selection of a few time series.

  22. LVG

    The best part is watching “passive” advocates scramble to defend their ideology in the face of what is clearly a factual debunking of their ideas. They’re like a cult thinking their “bogleheaded” ideas are so much smarter than everything else. Turns out they’re doing most of the things they criticize.

  23. Cullen Roche

    It’s not “us” vs “them”. I am an advocate of low fee indexing. I just don’t think you should go into the asset allocation process by thinking that you’re being passive or not making forecasts about the future. I think you should go into the process constructing a portfolio based on a sound understanding of future probable outcomes, a sound understanding of how certain instruments apply to the capital structure and do so in a fee and tax efficient manner. All of this requires forward looking approaches and “asset picking”. We are all “asset pickers” no matter how “active” we are after the initial investment.

    Allocating assets isn’t passive. Maintaining that portfolio isn’t passive. The portfolio changes and the risks/rewards in the underlying assets change over time. Sure, indexing is “passive” relative to day traders and stock picking junkies, but who cares about them? No one is benchmarking themselves relative to those speculators. Go into this with your eyes wide open. The person who sacrifices process in favor of “low fees” will hurt their own results….

  24. DevilsDictionaries.com

    I’m an advocate of ‘lazy investing’:

    1. Trade as little as possible. Do not change your asset allocation more than once in a couple of years.
    2. Absolutely ignore P/E ratios, especially during the most dramatic periods. (Especially ignore Shiller’s P/E.)
    3. Instead, pay attention to credit markets, monetary aggregates and interest rates. These statistics may help you to detect bubbles or undervalued markets on time.
    4. Invest in low-cost instruments (index funds).
    5. Avoid emerging markets; their potential to disappoint investors is immense.

  25. Cullen Roche

    I might take some issue with 5., but other than that I totally agree. I think the key point is that portfolios are dynamic as is risk and our perception of risk over the course of the business cycle. Therefore, altering your allocation at times is not just prudent, but necessary. This doesn’t mean you need to trade actively or even monthly or even annually. But you should be mindful of the fact that we are not dealing in a static system. Very few “passive” indexers seem to understand that point….

  26. Cowpoke

    Well, it does exist both passive and active and all points in between. I think you stated this correctly in your OCD kicking in.

    Your taking it a bit to the inth degree. I have at times in the past woke up and sat at the computer activly trading with my money all day long.

    I would consider that active. I have also simply let it sit in a fund and not touched it for multiple qtrs doing nothing. I consider that passive.

    I think what you as a full time employee in the field of finance and investment view as active/passive and what Joe public views is two different things.

    Heck just by waking up in the morning we are all active so this is splitting hairs.

    People (regular joes) don’t “know what the drivers of that portfolio are and what the probabilistic outcomes are.”

    They don’t have the time. They are to busy building things working rasing kids.
    Perhaps I am speaking from a comman folk approach and your post is intended more towards those who actually work in the finance community managing peoples money.

    You know how I get stuck on these “NOMINAL” words.. LOL 🙂

  27. DevilsDictionaries.com

    Point #5 reflects my personal prejudice, because I used to work as an emerging markets analyst (macro and M&A, mostly Russia and Asia.) Since that time I don’t think I understand the EM 🙂

    You’re very true we are not in a static system and simply “buy and hold” may cost an investor dearly.

  28. Paul Placeway

    Kill EMH? Sure, okay: back in 2011, Maymin used a method from technical Computer Science to show that EMH (even Weak EMH) is too powerful, and therefore unlikely to be true.


    “The thrust of this paper is that the information cost of searching all possible patterns in a sequence of prices is an exponential task, so as the amount of data gets large, at some point it will overwhelm the aggregate ability of all investors to discover patterns, and therefore there should be positive returns to those who do find the patterns, at least until those patterns become widely known.”

    * P=NP overview in Wikipedia: https://en.wikipedia.org/wiki/P_versus_NP_problem One of the upshots of NP problems are that solutions are easy to check post-hoc, but hard to come up with.

  29. Commish of hangin'

    After reading the section in the book “How Markets Fail” about Friedman/Chicago School economics, I came away with the idea that there’s an unhealthy amount of handwaving that goes on when you confront one of their economists about the many, many holes in theories such as the Efficient Market Hypothesis. That does not make for good academics.

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