The Theories That Drive Active and Passive Investment Strategies

Daniel J. Greenblatt, CFA® BY: Daniel J. Greenblatt, CFA® 06.04.18

A Comparison of the Efficient Market Hypothesis and the Adaptive Market Hypothesis

As our Director of Investments, Emmett Maguire III, mentioned in a past blog post, the decision between active and passive investing is not black and white.

Proponents of a purely passive approach often base their investment philosophy on the Efficient Market Hypothesis (EMH). The spirit of this theory can be gathered from the following age-old economics joke:

A hundred-dollar bill is lying on the ground. An economist walks past it. A friend asks: “Didn’t you see the money there?” The economist replies: “I thought I saw something, but I must’ve imagined it. If there had been $100 on the ground, someone would’ve picked it up.”

As the joke implies, the Efficient Market Hypothesis states that all information about a given company is incorporated and reflected in the price of its stock. If stocks are always trading at their fair value, investors would find it impossible to generate excess returns. Therefore, one should use index funds.

From a philosophical perspective, Lake Street does not fully agree with the Efficient Market Hypothesis. Instead, we are believers in the Adaptive Market Hypothesis (AMH), proposed by MIT Professor Andrew Lo, which is a cornerstone of our investment philosophy.

Adaptive vs. Efficient Markets – How They Drive Active vs Passive Investingt Markets

While there are varying degrees to the EMH theory, it predominantly assumes that market prices reflect all available information. In aggregate, investors are rational, and any new information is quickly absorbed by the market–the result being that investors generally cannot outperform the market on a risk-adjusted basis after fees, taxes, and transaction costs. Strict believers of the EMH feel traditional active management is largely a fool’s errand and will result in underperformance after externalities like fees are considered. A believer in the EMH would only use low-cost index funds and would strongly advocate for passive investing.

In contrast, the Adaptive Market Hypothesis takes the Efficient Market Hypothesis and adds a behavioral finance perspective. The AMH theory assumes that successful investors apply heuristics or mental rules of thumb until they no longer work. Alpha converges into Beta as mispricings get exploited. Investors are neither always rational nor irrational. Instead, investors are biological entities whose actions are shaped by the forces of evolution.

The AMH leads to these five conclusions:

  1. The relationship between risk and return is not perfectly stable. It changes over time as the competitive environment changes.
  2. Active management of investments can find opportunities to exploit inefficiencies from time to time
  3. Adaption and innovation are key to survival
  4. Survival is the only objective that matters
  5. No strategy will work all the time

What Does All This Mean for the Investor?

Most markets are efficient like the EMH predicts, but there are spaces where active management can have a clear advantage. Subsequently, both active and passive strategies have a place in an investor’s portfolio.

Revisiting our five conclusions from above, the first conclusion highlights that risk and return dynamics change over time, so simply looking at past performance is an inadequate strategy. It is for this reason that we must disclose “past performance is not an indication of future returns” at the bottom of this post.

Instead of purely focusing on past performance, Lake Street’s investment process places a strong emphasis on what we call continuous improvement, which we define as efforts made to increase competitive edge(s) or reduce cognitive mistakes. This method is directly related to conclusions three and five from above­–both of which require active management to innovate to outperform their peers.

The concept of continuous improvement is less concrete than quantitative figures like past returns or standard deviation, but we would argue is that it’s more important in the process of selecting outperforming active managers. Evaluating the continuous improvement of a fund manager is largely determined by looking at their process and meeting with management. Doing so requires considerable resources, but ultimately is more valuable than any information one could gather from a pitch book.

To conclude, while many markets are efficient and should be indexed, there are still select opportunities for active management that will oscillate over time. By identifying active managers that place an emphasis on continuous improvement, we believe these opportunities can be exploited for the benefit of our clients’ personally tailored portfolios.

Sources
http://opim.wharton.upenn.edu/~sok/papers/l/JPM2004.pdf
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