Is Private Information the Only Way to Beat the Market?

W. Ben Hunt Ph.D. is a unique and interesting voice in the investment community today. His newsletter, Epsilon Theory, uses historical and game theoretic analytical lenses to offer a distinctive perspective on the market and economy. Hunt’s take on market activity is the product, at least in part, of an idiosyncratic background. He started out in academia, teaching political science for more than a decade, before entering the investment industry in 2003.

Always interesting, often provocative, Hunt’s perspective is certainly worthy of investors’ attention. Yet, in a recent thread on Twitter, Hunt made a startling claim:

“Alpha = private information. Period. Full stop.”

That notion is far from new. The efficient market hypothesis has been around for decades, and continues to have many adherents, especially in the ivory towers of academia (despite the reams of real world evidence debunking the hypothesis).

Hunt’s contention is especially unsettling. He argues that all perceived market-beating performance (“alpha”) is misattributed, except in the case of investors who possess private information. Can he possibly be right?

The illusion of alpha

Hunt contends that the pursuit of genuine alpha, in the absence of information asymmetry, is a fool’s errand and that the people pursuing it are effectively deluding themselves:

“I understand that we'd like to think that smarts + process + time = alpha. It's one of the little lies that we tell ourselves to get through the day. Here's the 10-year chart of Berkshire vs. S&P total return [they move tightly together]. Without private information (and often with it) THERE IS NO ALPHA.”

In this reading, alpha is merely an illusion, one that is compounded by investors’ desire to believe they can beat the market. He uses Berkshire Hathaway (BRK.A, Financial) (NYSE:BRK.B) as an example of the illusion in practice:

“For more than a decade, Berkshire has been an exorbitantly expensive S&P 500 tracking stock. Sorry.”

It is true that Berkshire has failed to beat the market over the last decade or so. But Berkshire is also a massive conglomerate, which has led to some degree of discount. A heavily followed, expansive, mature business is perhaps not the best example of the absence of alpha. But Hunt does make his point in highlighting a company whose boss, Warren Buffett (Trades, Portfolio), is renowned as an investment guru without equal. No matter how you slice it, Hunt’s argument is a scathing rebuke of a core tenet of value investing.

The death of active management

Hunt does not stop there. He argues that private information, and more specifically the laxer government definitions of what constituted private information in decades past, are what allowed Buffett and other active managers, such as Peter Lynch, to beat the market. Since the rules have been tightened, active management has lost its lustre:

“When did fundamental active management begin to die? In August 2000, when Reg FD made it illegal to get private information from public companies. If Reg FD dated back to 1980, you would have never heard of Peter Lynch and Warren Buffett (Trades, Portfolio).”

Hunt’s point regarding stricter disclosure requirements is a fair one. Regulation FD (Fair Disclosure) did away with a major perk that used to benefit big money managers. Before 2000, companies could engage in selective disclosure, meaning they could provide a range of market-moving information to some shareholders and not others. This tended overwhelmingly to benefit large institutions at the expense of smaller players and individual investors. Reg FD thus leveled the playing field to a degree. But did it really kill the ability of active managers to beat the market? We do not believe so.

No expectation of active investment renaissance

Active managers lost a valuable tool in 2000, but that is not the only major shift in the investment landscape over the past two decades. The rapid growth and surging popularity of passive investing, strategies and vehicles that aim to mimic the market return, has also shifted the mechanisms of the market.

We have discussed this phenomenon in previous research notes, including the growing signs of an inflating passive bubble, as well as the fallout that might occur were it to pop. We have argued that the growing dominance of passive strategies has opened - and will continue to expand - opportunities for thoughtful active investors. Hunt apparently disagrees with that conclusion:

“And if you’re hoping for an active management renaissance...as passive, price-insensitive investing grows as a % of flows, alpha becomes *harder* to achieve, not easier. Alpha creation is not a mean-reverting phenomenon.”

It is true that alpha-creating strategies are not “mean-reverting” phenomena, but that is somewhat besides the point. The idea that achieving outsized returns will actually be harder as passive funds grow as a proportion of total invested capital strikes us as a bit preposterous. Some strategies may not suit. But the inherent inefficiencies created when fewer resources are dedicated to the process of price discovery can be exploited.

Defending the idea of value

The core premise of value investing that assets can be bought cheaply, or for less than they are really worth, thanks to inefficiencies or irrationalities in the market. These effects lead to asset mispricing, which can be exploited by the bargain-hunting value investor. Hunt contends that the very idea that a security can be mispriced is flawed:

“Something is only ‘mispriced’ if there is some active price discovery that the former price was wrong. You're making the assumption that ‘true’ price comes from fundamentals. THERE IS NO SUCH THING AS A TRUE PRICE.”

Hunt is correct when he says that terms such as “true price” and “fair value” do not adhere to a concrete reality per se. But this is little more than a semantic argument that collapses upon contact with reality. To conclude that, because the true price of a security is more or less a fiction, securities can never really be mispriced is wrongheaded in the extreme. Sure, there is no definitive correct share price or valuation at any given time, let alone across a time series. But that does not mean investors are incapable of identifying situations in which a price is wildly out of alignment.

Taking the most conservative response to Hunt’s thesis, we would contend that there are opportunities for investors to identify directional mispricing of a stock, even if they cannot attach anything so concrete as a “true value” to it. It is easier to identify a cheap stock than to determine “how cheap” it is.

Verdict

While Hunt offers fresh food for thought that all investors should digest, we must conclude that he falls short of the mark in his denunciation of active investing’s value in the absence of private information. As the market grows increasingly passive, the opportunities for price discovery will rise.

Value investing is not dead and Hunt has not killed it. There are opportunities out there for the taking. They are not always easy to find, but the search is not a fruitless one - or without reward.

Disclosure: No positions.