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John Engle
John Engle
Articles (467) 

Can Investors Beat an Efficient Market?

Most advocates of efficient markets decry stock-picking, but some see room for coexistence

September 24, 2018

The Efficient Market Hypothesis, which finds its genesis in the famed Chicago school of economics, is one of the most important elements of contemporary economics. In essence, the EMH contends that the stock market is efficient, meaning that all current public information about companies is completely and accurately reflected in their share price. Stronger forms of the EMH exist, extending the claims of efficient information processing to new information, and even non-public information.

The important thrust of the EMH is this: Investors cannot beat the market because stock prices accurately reflect reality. There is thus no opportunity for arbitrage and no hidden opportunity to exploit. If true, successful value investing, especially deep value investing, ought to be impossible, since there are no truly undervalued stocks to find. Growth stock investors and traders would fair no better, since any growth potential that a bustling company might have will be priced in already.

Love it or hate it, the EMH has had a profound impact on economics, both as a theoretical and a practical discipline. But one would think that any active investor, regardless of style, would recoil at the notion that market-beating returns are impossible. As it turns out, that is not quite so after all.

Introducing the pro-EMH money managers

Clifford Asness and John Liew are somewhat unconventional money managers. AQR Capital Management, the firm they founded 20 years ago, has grown to include about 900 employees and has over $200 billion in assets under management. They are not unique in their focus on quantitative strategies, or in their academic backgrounds, though they do stand out somewhat. What really sets them apart is how deep their ties to academia run. Both are PhD economists and students of Eugene Fama, the father of the EMH.

Asness and Liew are certainly disciples of Fama’s view of market efficiency, and they freely admit that the EMH informs AQR’s investment decisions. But that does not mean there is no way to make money in the market.

Believers but not purists

In an article on the subject of the EMH, Asness and Liew made a very important point that many critics (and supports, for that matter) of the EMH can often fail to understand:

"The broad point is that we believe markets are wonderful. They’re the best system for allocating resources and the spread of freedom and prosperity that the world has ever seen. But they are not magic. As we, and again even Gene Fama, have said many times, they are not perfectly efficient. How efficient they are is partly a function of the care and thought we put into designing them and the rules around them. Many of the actions we collectively take actually hamstring markets, making them less efficient, and then the cry invariably goes out: See, blame the believers in markets! That needs to change."

Asness and Liew acknowledge that market efficiency is not an absolute. Rather, efficiency is a function of how a particular market is designed. Therefore, functional markets are rarely, if ever, purely efficient. But that does not mean the EMH is bunk. Quite the opposite. They contend that modern capital markets have grown increasingly efficient due to better information and structural improvements.

Can you beat an efficient market?

Asness and Liew proposed an interesting solution to the dilemma created by the EMH. They argued that there are better ways of getting price and risk signals, and of managing cost-raising frictions, in order to “beat the market” in an oblique fashion:

"Implementation details matter. Take value as an example. Does the measurement of value end at book-to-price ratios? In our research we find that there are many things you can do to (mildly) improve on a sole reliance on the academic version of book-to-price ratios. Does that mean we are moving away from efficient markets to being inefficiency guys trying to come up with some secret sauce to add value without risk? Not necessarily. It might simply be that in real life there is a value risk factor, but simple academic book-to-price isn’t the best or only way to measure it. (We know of no theory that argues that book-to-price is perfect.) By improving on your signals, you may get a cleaner read on the underlying risk factor.

Also, it is most certainly the case that with sloppy trading you can easily throw away any expected return premium — whatever its source — that might exist around these strategies by paying too much to execute them (and sloppy can include overpaying in a slavish, high-turnover attempt to own precisely the portfolios from the academic papers). Clearly, the line between active and passive management starts to blur with these types of investment strategies."

In other words, there are ways to refine models to get a clearer grasp of underlying realities. That might sound like a criticism of the EMH in itself, but it could be argued that it is simply an acknowledgement that most existing financial models, both academic and practical, fail to capture the underlying market reality.

Thus, while the market may behave efficiently overall, inadequate models will leave money on the table. A refined model, on the other hand, can generate what might be called a species of alpha.


We remain highly skeptical of the EMH as a governing principle of financial market analysis. Certainly, it seems to get too much prime of place in the way finance and investment is taught. In some ways, the AQR managers’ comments show why relying on simplified models can cause poor decisions based on a fundamentalist belief in efficient markets.

Markets are undoubtedly far more efficient than they once were. But irrationality still reigns much of the time. That leaves room for value investors and active managers to profit even now. We doubt there will ever be a time when all alpha is squeezed out of the market.

Disclosure: I/We own no stocks discussed in this article.

About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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