Optimal mutual funds in a world of bubbles
By Scott Sumner
One argument in favor of the Efficient Markets Hypothesis is that if bubbles existed, it should be possible to make large excess returns by betting on an eventual collapse of the bubble. And the famous counterargument often made is that:
The markets can stay irrational for longer than you can stay solvent.
Thus people who felt that tech stocks were overvalued in 1996, or American real estate was overvalued in 2003, and who shorted tech stocks or MBSs, might go bankrupt before their accurate predictions were finally vindicated.
There are lots of problems with this argument. First of all, it’s not clear that stocks were overvalued in 1996, or that real estate was overvalued in 2003. Lots of people who made those claims later claimed that subsequent events had proven them correct, but it’s not obvious why they were justified in making this claim. If you claim X is overvalued at time t, is it vindication if X later rises much higher, and then falls back to the levels of time t?
But let’s put that common cognitive bias aside, and consider what the world would look like if bubbles were a real phenomenon. The first thing to note is that the term ‘bubble’ implies asset mis-pricing that is easily observable. A positive bubble is when asset prices are clearly irrationally high, and a negative bubble is when asset price are clearly irrationally low. If these bubbles existed, then investors could earn excess returns in a highly diversified contra-bubble fund. At any given time there are many assets that pundits think are overpriced, and many others that are seen as underpriced. These asset classes include stocks, bonds, foreign exchange, REITs, commodities, etc. And even within stocks there are many different sectors, biotech might be booming while oil is plunging. And then you have dozens of markets around the world that respond to local factors. So if you think QE has led Japanese equity prices to be overvalued, and tight money has led Swiss stocks to be undervalued, the fund could take appropriate short positions in Japanese stocks and long positions in Swiss stocks.
A highly diversified mutual fund that takes advantage of bubble mis-pricing should clearly outperform other investments, such as index funds. Or at least it should if the EMH is not true. I happen to think the EMH is true, or at least roughly true, and hence I don’t actually expect to see the average contra-bubble fund do well. (Of course individual funds may do better or worse than average.)
The Economist recently reported that Warren Buffett has not done as well in recent years:
Mr Buffett used to argue that Berkshire’s book value per share, rather than its share price, was a good proxy for its long-term worth. But the group’s book value has stopped outperforming the broader stockmarket–in fact it has underperformed it in five of the past six years (see chart). So now Mr Buffett has begun to argue that book value is no longer such a good measure, and to give greater prominence to Berkshire’s share price. This sort of goalpost-moving is a habit of lesser conglomerates than Berkshire, and is hardly a promising sign.