By Scott Sumner
When I started blogging in February 2009, I immediately got into lots of arguments about the Efficient Markets Hypothesis, which I think is “true” in the sense of being a good social science theory, a useful approximation of reality. I cited the fact that managed mutual funds tended to underperform index funds, and that those funds that did well one year often failed to repeat the next.
The counterargument was that hedge funds had consistently outperformed the markets, and that hedge fund managers were much smarter that ordinary mutual fund managers. After all, many of them are billionaires. Warren Buffett was just as skeptical as I was of the supposed forecasting ability of the “masters of the universe” that run the big hedge funds, and decided to put his money where his mouth was:
Warren Buffett continues to hold the lead in his bet that most investors are better off in a stock index fund than in a sophisticated hedge fund that charges hefty fees.
After eight years of the 10-year bet, Buffett’s chosen index fund holds a commanding lead over a collection of hedge funds even though the hedge funds performed slightly better in 2015. . . .
The low-cost Vanguard S&P 500 Admiral index fund Buffett chose is up 65.7 percent since the bet began. Protege picked five funds that bundle hedge funds that are collectively up 21.9 percent, on average.
That gap is so large that I doubt it can be closed in the final two years. And it also seems too large to be explained by any differences in the riskiness of the two portfolios. Let’s face it, hedge funds just got lucky for a few years, and their reputation rests on that hot streak.
That’s not to say the EMH is perfect; perhaps Buffett is smarter than the market, but other billionaires just got lucky. But even if that were true, even if the EMH applied to everyone except Warren Buffett, it would be a far more accurate model that the vast majority of social science theories.
Other criticisms of the EMH have also fallen by the wayside in recent years. The other housing “bubbles” (Britain, Canada, Australia, New Zealand, etc.) never collapsed like the US and Ireland. People who predicted the housing bubble (Roubini, Shiller, Paulson, etc.) have done poorly since. Markets have been more accurate than the Fed. Conservatives who said QE would lead to high inflation were wrong. Markets were right. Liberals who predicted the 2013 austerity might lead to a recession were wrong. Markets were right.
The EMH will always be a punching bag, because people are arrogant enough to think they are smarter than the markets. But it won’t go away—100 years from now finance textbooks will still teach the EMH.
Richard Rorty once said something to the effect that if you claim X is actually true, despite most people believing it to be false, you are implicitly forecasting that most people will eventually recognize X as true. (As there is no such thing as objective truth.) That’s how I feel about the EMH–I predict that it will eventually be regarded as true.
PS. Here are real house prices: