Economics and the mid-life crisis have much in common: Both dwell on foregone opportunities

C'est la vie; c'est la guerre; c'est la pomme de terre . . . . . . . . . . . . . email: jpalmer at uwo dot ca

. . . . . . . . . . .Richard Posner should be awarded the next Nobel Prize in Economics . . . . . . . . . . . .

Wednesday, March 16, 2005

Are Markets Efficient?
Our Pension Board Thinks Not

I never fully understood the "efficient markets hypothesis" (as if I do now) until I read A Random Walk Down Wall Street by Malkiel. It is a very clear exposition of why there are no discovery values out there for you and me and why I do best by putting my money in a passive index fund.

About 20 years ago we had a near revolt at this university when several economists and other financial experts realized that the committee managing our pension funds was trying to play the market with our money and was doing a bad job of it. My colleagues set in place a series of changes that favoured passive management, index funds. They also attempted to diversify into some mid-cap and small-cap funds, but were forced to look into small-bet active managers because there were no index funds for these components of a diversified portfolio.

Now I learn that gradually the pension fund is employing active management at all levels. When I asked a member of the pension board about this, he said, (paraphrased)

"Active management has no advantages in the U.S., but in Canada markets are not efficient, and we can gain about 100 basis points above the index with judicious active management; in Europe, judicious active management returns about 300 basis points above the index."

This surprises the heck out of me. If it is true, and if the MERs of the funds we employ to do this active management do not erode all the gains, why have these gains not been competed away? Why are Canadian and European markets so inefficient?

And if those markets are inefficient, I anticipate that the gains we have seen in the past few years will disappear in the future as the markets become more efficient.
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