Will McClatchy

An Interview with Professor P. Raghavendra Rau, Assistant Professor of Finance at Purdue University

The clever and clear study "A Rose.com by Any Other Name" suggests there may be inefficiencies, especially in markets of great fluctuation. It does not suggest that these inefficiencies are easy to spot.

IndexFunds wanted to know more and asked Professor Rau about the relevance of the above study to investors. We particularly wanted to know if inefficiency due to irrationality is easy to spot and exploit. Apparently it's not.

The elegant irony here is that inefficiency is both fodder of money managers hostile to indexing and insurance of the strength of efficient market theory which lays the foundation for indexing. Opposing forces attract.

-Will McClatchy

IndexFunds: Why is efficient markets theory so central to investing? Can inefficiency help an astute investor achieve above average return consistently?

Rau: Basically, efficient markets theory is one of the fundamental paradigms of finance. It underlies nearly everything we theorize about. If markets are efficient, then financial engineering, changing the method of depreciation or merger accounting etc for example, should have a strong potential for increasing value. Take an article in the September 13 issue of Business Week for example. The article called "When Capital gets Antsy" (page 72-73) says that if managers focus simply on maximizing their short-term results and ignore their long-term (because shareholders are completely focused on the short-term), it can lead to disaster for the firm. The article says for example that "Sunbeam imploded" when the short-term payoffs failed to materialize. If markets were efficient then managers need not worry about short-term or long-term focus, they should just Rau: Now, when looking at the Internet, this has the potential to completely shake up the market for retailing, distribution and other areas. So investors are extremely anxious to try to buy into the industry, because while a vast majority of them might fail, a few of them might really pay off big. In some ways, it is akin to buying a lottery ticket. This is however rational behaviour on the part of the investors.

What is irrational is the effect of a name change if nothing else is going on in the firm. Suppose a firm announces a name change because it is now in a new (Internet-related) business and the name change draws attention to this. In this case, a massive investor reaction to the name change is rational. What is not rational is a positive reaction if either the company has nothing to do with the Internet or if the company were already an Internet company (no new news). This suggests investors are not doing their homework properly and consequently they are behaving inefficiently.

Is the market itself inefficient? It used to be thought that if irrational investors existed, they would be driven out of the market by smarter more rational investors, who would take the opportunity to make money. It has been shown that this will not be true if the rational investors have to cash out of the market before the irrational traders have realized their mistakes. Consequently, it may not always be true that the market will be perfectly efficient.

However, I believe that the market will always tend towards efficiency. Research gets published. After a paper on the positive  long-run performance of firms announcing share repurchases, buyback funds were set up to take advantage of exactly this phenomenon, thus driving the potential returns towards zero.

Can we predict where markets might be inefficient? One problem is that we do not have a theoretical model of inefficiency - what we have is a bunch of anomalies which may indicate market inefficiency. So prediction is almost impossible. In addition, alternative explanations have been suggested for these anomalies and so we have a current on-going argument as to what these results really mean. The dot com paper evidence is evidence against market efficiency, but again we cannot conclusively say that markets are inefficient on the basis of these results.

One last point about lucky investors. It is probably unreasonable to expect to be lucky every single time on the stock market. The efficient markets hypothesis tells us that we cannot consistently make money on the market - it does not say we can never make money.