Investing in Inefficient Markets and the Efficient Markets Hypothesis

There’s a nice little point being made here in the WSJ. We’ve all pretty much internalised the Efficent Markets Hypothesis: that markets are efficient at processing the information which might affect prices in a market. We’ve also all pretty much internalised the idea that as a result of this we’re not going to beat those markets. And nor are most fund managers most of the time.

To which, as the WSJ says, the come back is yes, but there are plenty of markets out there (weird foreign ones say, or small caps in certain industries) which are still inefficient because, well, there’s not enough players in them to make them efficient. And it’s certainly possibly true that this is so.

However, what the WSJ then points out is that if this were so then those funds investing in those inefficient markets should be beating the general market: and while certain funds do do so, no class of funds does so regularly.

All of which pretty much shoots down the contention that there are those inefficient markets in which excess returns can be gained. Or, perhaps, that the fund managers who claim to be following that strategy aren’t very good at following it.

There’s just one point I’d add to this. Something from personal business experience at the wierder end of the metals market. There are most certainly inefficient markets here. When the entire global market for lutetium (yes, I know, you’ve never heard of it) is three or four tonnes a year, worth maybe $1.5 million all told, yes, among 7 billion people we’d think that was a pretty inefficient market.

And it is a pretty inefficient market, truth be told. However, it doesn’t take much interest, much volume, for a market to become efficient in things like price discovery. Take, say, tantalum as an example. Global usage is of the order of 1,000 tonnes a year. Worth, well, depends upon which day you look at the price but in the $300 million to $500 million range perhaps? Yes, I know that looks like a lot of money but that’s the entire size of the whole global market: this is still a very small market indeed. But a pretty efficient one. Absent political problems you’ll not find prices varying by more than 2 or 3 % at any one time. The tantalum price in Hong Kong is roughly within transport costs of the price in Rotterdam, on the other side of the world.

Please note, I’m not saying that the tantalum market is “efficient” in the sense that the market for Apple stock is. Rather, just pointing out that a market doesn’t have to be very big before it’s much closer to that efficient end of the spectrum than the inefficient one at which you can make tonnes of money by exploiting the inefficiencies.

That is, inefficient markets are, almost by definition, small markets. Meaning that they’re just not open to profitable exploitation by any large number of people: for as soon as there’s a large number of people they’re not small markets and thus not inefficient.

By: Tim Worstall

http://www.swissmetalassets.com/investing-inefficient-markets.html