Efficiently Inefficient: How Smart Money Invests & Market Prices Are Determined

Pedersen’s book Efficiently Inefficient – How Smart Money Invests & Market Prices Are Determined compares economic theory and real-world market mechanisms to posit that markets are ‘efficiently inefficient’. The book is welcome because its author has both the academic and the practitioner credentials to investigate this topic.

Economic theory is based on the joint notions that (i) any economic activity, whether labour or capital, has a price and an opportunity cost, and (ii) that production output should earn an economic rent. The market then clears and finds an equilibrium in which all resources are utilized in the best possible way. The efficient (financial) market hypothesis is based on the idea that when markets clear the prices are ‘right’, in that they reflect all available information and risks.

In the real world, market mechanisms identify the market price. Economically motivated activity plays a role in these mechanisms. For example, an arbitrageur seeking to earn economic rents prices the assets within the arbitrage limits. In Pedersen’s terminology, the resulting market ‘equilibrium’ is an efficiently inefficient market. In this market, prices can deviate from their fundamentals up to a certain degree, and arbitrage capital must ensure they do not deviate too much.

The book is organized as an introduction and four chapters. The four chapters cover Active Investment, Equity Strategies, Asset Allocation and Macro Strategies, and Arbitrage Strategies and include interviews with world leading experts in their own field of asset management. In the Introduction, Pedersen discusses the characteristics of efficient and inefficient markets and states that an efficiently inefficient market is ‘somewhere in between’. If the market were efficient, active management would not pay off because prices would fully reflect fundamentals and risks. If the market were inefficient, beating the market would be easy. The real-world market is therefore neither efficient nor inefficient. Prices can deviate from their fundamentals and risks making the market inefficient, but because beating the market is not easy the market must be inefficient to an efficient degree. This in turn means that the market cannot be beaten by just anybody, but only by experts. Pedersen lists a number of investment strategies that keep the market prices close to fundamental values.

Having discussed the reasons why markets cannot stray too much from efficiency, the author then tackles the question of why they may deviate from efficiency at all. It is important to keep in mind that, in this search for causes of inefficiency, blithely pointing to catch-all phrases such as ‘investor irrationality’ or ‘cognitive biases’ may not be enough. One must also show why it ends up being difficult to exploit these putative deviations from efficiency. As long as a few cool-headed and deep-pocketed investors exist, the vagaries of the potentially irrational investors would be washed away. See for example Shleifer and Vishny (1997) on limits to arbitrage. Markets, the author’s central thesis states, are efficiently inefficient, not stupidly inefficient. It is therefore refreshing that, unlike much current literature on the topic, the author sets the bar for clearing the inefficiency hurdle sufficiently high.

Since Pedersen is an expert on liquidity research, he often cites liquidity as an explanation for the deviation of prices from their fundamentals. To support his thesis he illustrates several relevant case studies, such as the 2007 Quant Crisis, the 2010 Flash Crash and the dual-listed securities. Since a liquidity crisis is a shock-driven market failure that would not happen in a perfectly efficient market, and since exploiting liquidity shocks is possible but difficult, it certainly qualifies as a potential source of ‘efficient inefficiency’. However, since the identification of the sources of difficult-to-arbitrage inefficiency is, in a way, the heart of the book, this reader would have liked to see the discussion of other potential sources of inefficiencies: perhaps regulatory constraints (Worah, Amey, and Ahmedov 2015), imperfectly aligned agent-principal relationships, or taxation, to name a few. One gets the impression that the choice of liquidity as the main cause of deviations from efficiency may owe more to the familiarity of the author with the topic, than with the pervasive nature of liquidity as the main source of efficient inefficiency.

Although Pedersen’s description of how the market functions is intuitively appealing, it leaves several questions unanswered. For example, it is not clear what price deviation from efficiency makes the market inefficient in an efficient manner. Admittedly, according to Gene Fama, the efficient market hypothesis is indeed a joint hypothesis of an asset pricing model and efficiency. So, testing market efficiency requires a model against which the market behaviour can be benchmarked. While this is well known, it is hard to understand why, say, dual-listed shares of Unilever can deviate up to 20% (Figure 9.7 on page 149), as one may think that for one of the largest companies in the world a ten-times-smaller deviation could already be understood as efficiently inefficient.

Another current-day example is the following. China A and China H shares have recently displayed a 40% spread (see Figure 1). The spread can perhaps be explained by capital controls, and trying to beat the spread is risky and difficult. However, what does not seem plausible is that a 40% spread should be efficiently inefficient, unless one rather tautologically describes as efficiently inefficient any market which is difficult to beat. If one adopted this catch-all definition, then also roulette or black-jack would be efficiently inefficient, as any honest gambler will testify. The attraction of the liquidity explanation is that it introduces a ‘perturbation’ of the efficient solution, not a complete departure from the well-established theoretical asset pricing framework investors and academics are familiar with. However, as an explanation of ‘pricing puzzles’, liquidity is probably less universal than the author suggests. And unfortunately, when a liquidity-like ‘perturbative’ link to an efficient baseline price is absent, it becomes difficult to give a solid theoretical foundation to the concept of efficient inefficiency.

Figure 1. China A-shares premium to China-H shares.

In practice, Pedersen defines the conditions that determine efficiently inefficient markets, describes the market behaviour, and then lists measures of risk and performance. Thus, his approach is descriptive rather than prescriptive: the book shows that an efficiently inefficient market can be quantified, but does not propose a model against which market behaviour can be benchmarked.

As Pedersen writes: ‘However, when I really wanted to understand the details of how trade execution or margin requirements actually work, I often hit a roadblock. As an academic outside the trading floors, it was very difficult to get to the bottom of how markets actually work. At the same time, traders who knew the details of the market did not have the time and perspective to do research on how it all fits together’. This is left for the reader.

Tapio Pekkala
Pacific Investment Management Company (PIMCO)
© 2016, Tapio Pekkala

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Tapio Pekkala

Tapio Pekkala holds a PhD in Economics from the University of Chicago and is currently Senior Equity Researcher at PIMCO. He worked previously as Senior Analyst at the Norwegian Sovereign Wealth Fund.