We closed yesterday’s post on whether markets are efficient with the conclusion that it could be possible to beat the market. But, to do so, we would need either better information or to view things differently—specifically referencing time horizons as one way to do that. Let’s start with a couple of areas where better information is a real possibility. Then, we’ll take a deeper look at the second idea, which is both more subtle and more interesting.
Information Asymmetry
When we are looking for an information edge, we have to be specific about what that means. Here, I am talking about an information asymmetry between what is actually the case and what the market believes. The most famous examples of this revolve around insider information— where the market believes one thing about a company and insiders know another—but there are also many macro examples. The hedge funds that made so much money in The Big Short, for example, were betting on information about the housing and mortgage market that was substantially different than the markets as a whole. They happened to be right and made a lot of money. Areas where that information asymmetry exists are fertile fields for active investors.
This idea fits in well with yesterday’s discussion, where we concluded it was hard to see what an individual could know about a large company that the myriad analysts and reporters hadn’t discovered. The obvious solution is to look at investments that are less covered: smaller companies, companies in foreign markets, fractured markets like real estate or private equity, and so forth. The less information publicly available, the greater the chance an active investor really does have an information edge.
So, how does this apply to my own investments? When I look at active versus passive, I have to be shown evidence that an active manager really does have enough of an information edge to justify its fees and then some. I can certainly see that case in markets that are obscure or inefficient, or at least relatively so. I have a harder time when markets are liquid, widely covered and (at least at the moment) apparently efficient.
Look For Other Opportunities
That is not to say, however, there are no opportunities. It just means that you might have to look elsewhere. Even if companies are efficiently priced relative to one another, this does not necessarily mean the market as a whole is priced rationally.
As an example, let’s go back to the dot-com boom. At that time, many companies made no money, so they could not be priced on earnings. Instead, alternative metrics (e.g., price per viewer) were used, and companies traded on that basis. Within that metric, pricing was efficient. The bigger picture, as we soon found out, is that pricing—while efficient—was not rational.
It’s All About Time Frames
That example, of looking beyond the immediate, takes us to one of my favorite illustrations of information asymmetry: using different time frames to evaluate data and investment opportunities. I have written about this before in the context of economic data, but it is just as applicable to investment decisions.