#56 Reflections on Investing : The Medallion Fund vs Market Efficiency

Professor and Nobel Prize winner Eugene Fama put forth the efficient market hypothesis and based on that concept Warren Buffet suggested that holding a passive investment in the S&P 500 was the best advice for most investors. If the market were efficient and if passive investing was best for everyone, how can that be reconciled with the performance of Jim Simons' Renaissance Technologies Medallion fund.

Hello, welcome back to "Reflections on Investing" with the Cornell Capital Group. We've got a longer reflection this time, covering some very interesting topics on passive investing, market efficiency, and counterexamples to market efficiency, such as the behavior of the Medallion Fund. So, let's get started.

Last time, we talked about the equilibrium condition for the market and said that all shares have to be held. Let's think of the market as one point and all investors together as another. All investors, as a group, have to hold the market portfolio; otherwise, we wouldn't have an equilibrium. This means all investors, as a group, can never underperform or outperform the market. They are the market. This implies that if individual investors are going to outperform the market, they have to do so at the expense of other investors who underperform. That seems like a problem, and it actually gets a bit worse when we consider the Efficient Market Hypothesis.

This hypothesis was originally put forward by Eugene Fama in 1970 and has attracted a great deal of attention ever since. However, it's often misunderstood. Let me see if I can explain it, starting with something perhaps more familiar to most people: betting on football games. In the football betting market, for example, casinos in Las Vegas aim for an equal amount bet on each side. They adjust the price, or the point spread, to ensure this balance. Saying the football betting market is efficient, in Fama's sense, means that the point spread accurately reflects the relative abilities of the two teams.

Applying this to the stock market, saying the price of Apple is efficient means the current price correctly reflects all future profits Apple is expected to deliver, discounted back to their present value. The Efficient Market Hypothesis suggests that investors cannot consistently outperform the market by analyzing and picking stocks because the market price already includes all known information.

Given this, one might argue for buying a passive, highly diversified index fund, like an S&P 500 Index Fund, since you can't pick winners or losers ahead of the market. Warren Buffett has recommended this approach for most investors, though he personally doesn't follow it, believing he can beat the market.

However, there's a contradiction in the idea that everyone should buy a passive index fund. The market's efficiency relies on investors actively searching for bargains, buying and selling based on their research. If everyone were passive, how would prices be determined accurately? This conundrum was explored in a paper I wrote in the early 1980s and further developed by economists Sandy Grossman and Joseph Stiglitz. They theorized that the market must be sufficiently inefficient to reward those investors willing to do the hard work of analysis.

Evidence for market inefficiency is seen in the performance of the Medallion Fund, managed by Renaissance Technologies, which significantly outperformed the market from 1988 to 2018. This fund's success illustrates that strategies can exploit market inefficiencies, but they don't scale indefinitely without affecting market prices themselves.

Warren Buffett has noted similar constraints as Berkshire Hathaway grew, acknowledging the difficulty in finding massively mispriced opportunities at a large scale. This underscores the complexity of market dynamics and the challenge of consistently beating the market.

For investors, blindly accepting market efficiency isn't practical because the market's competitiveness and inherent inefficiencies mean there are opportunities to be exploited. However, unless you have significant insight or assistance, a passive fund might still be your best option. Yet, at Cornell Capital, we see problems with a purely passive approach, particularly concerning tax implications.

Buying individual stocks allows investors to manage taxes more efficiently than if they owned a diversified fund. This tax timing option is lost in a passive fund investment.

This has been a long reflection, much longer than our previous ones, but pondering the idea of market efficiency, what it means to you, and why it can't be universally true are valuable for managing your investments going forward.

Thank you for joining us on "Reflections on Investing" with the Cornell Capital Group.