Asset managers often use complex approaches when stewarding the capital of their clients. Consider a discretionary active manager seeking to gain an edge: The manager may hope to get some large overarching qualitative question correct, such as does Company X have a long-term sustainable competitive advantage that will allow it to compound capital at an attractive rate? Conversely a quantitative manager may be hoping to get many smaller questions correct: out of the universe of securities, which ones show characteristics that correlate to attractive future returns in a statistically significant way?
Regardless of the approach, an allocator seeks to partner with managers whose processes lend themselves well to achieving a goal, be it achieving excess returns, dampening volatility or some combination of the two.
Since research has shown that neither quantitative nor discretionary styles are inherently better from a performance perspective, allocators must assess whether managers are likely to be able to capitalize on some inefficiency in the market using their strategy.
Michael Mauboussin, author and director of research at Blue Mountain Capital Management LLC wrote a research piece in February 2019 called “Who is On the Other Side? You Need Good BAIT to Land a Winner.” Mauboussin’s acronym is made up of what he sees as the four sources of market inefficiency: behavioural, analytical, informational, and technical. He goes further in providing examples of each to help connect the inefficiency with potential means of exploiting it.
Behavioural inefficiency: Mauboussin defines behavioural inefficiency as investors acting in a way that causes prices and intrinsic values of securities to diverge. He provides an example of investor overextrapolation to illustrate how investor expectations for stock returns in a given year are highly correlated to the returns in the past year. However, research has exhaustively shown that high valuations lead to low future returns. Since a year with high investment returns is likely to result in higher valuations, the expectation that high returns will lead to high returns in a subsequent period is a misguided one. An asset manager could factor this behavioural inefficiency into their capital markets expectations in order to gain an edge.
Analytical inefficiency: Mauboussin defines analytical inefficiency as a case arising when an investor can analyze information better than other market participants. His examples include having more analytical skill, weighting information differently, operating on a different time scale or updating one’s views more efficiently. Let’s consider time scale as it relates to value investment strategies. Managers employing these strategies will often seek to purchase securities as they face selling pressure due to temporary headwinds. They’re effectively operating on a longer time horizon than other market participants, which allows them to act in a manner beneficial to longer term returns.
Informational inefficiency: An informational efficiency arises when market participants have different information than others and have the ability to trade profitability on that information, Mauboussin wrote. For example, in the years prior to the implementation of Regulation Fair Disclosure, or Reg FD, by the Securities and Exchange Commission in the year 2000, information was distributed across United States market participants in a non-uniform manner. Publicly traded companies in the US were allowed to privately disclose material information to select investors or market participants before Reg FD was enacted. Since Reg FD came into effect, asset managers can no longer take advantage of the informational asymmetry that existed before it. Remaining informational inefficiencies are less fruitful and more difficult to exploit. Legal, non-traditional information that can provide material advantages to asset managers is generally quite expensive to gather, the Mauboussin paper noted.
Technical inefficiency: Technical inefficiencies arise when market participants must transact in securities for reasons unrelated to their intrinsic value, the paper said. These can be a result of regulatory considerations, internal policies, or even legal restrictions.
I often use fixed income markets as an example of technical inefficiency. A supporting thesis for active fixed income managers has historically been that the fixed income markets are host to non-economic participants, which is to say participants that are purchasing or selling fixed income securities for reasons other than yield. An example of this may be a pension fund or insurance company with a liability-matching mandate. There may be limited availability long duration fixed income securities to the point that these investors will purchase them purely to immunize their liabilities. An active manager could use credit and yield curve strategies with a focus in this area of the market in an effort to exploit this inefficiency.
It may be worthwhile for institutions to consider incorporating Mauboussin’s research into the manager due diligence process. For a manager’s edge to be persistent, one would hope that their strategy seeks to capitalize in some fashion on one or more of the inefficiencies discussed here. Managers may have sophisticated processes, teams and underlying philosophies, but if their strategy fails to exploit market inefficiencies, allocators can end up paying for subpar results.