Second thoughts about adaptive markets
David Stevenson, Research Associate, EDHEC-Risk, Chairman, ETF Stream and Columnist for the Financial Times (the Adventurous Investor), Investment Week and Money Week
To this observer, the great story of the last few decades has been the slow erosion of the passive meta narrative. Economists, and a few evangelical investors, spent many decades thoroughly versing the market in a simple idea. You can’t beat the market. Stop trying to second guess trends and themes and just buy the market in a simple, cost effective fashion. The academics almost by accident also stumbled upon the idea of risk premia but when you talk to this first wave of pioneers you can almost sense the caveats in their discussion of these risk premia – “ yes, they existed but really they’re not the big story” is a common refrain I hear from academic economists in their sixties and seventies.
This first wave have now been thoroughly overwhelmed by a more adventurous second wave of investors and analysts who have embraced a form of quantitative finance. Call it ESG, smart beta or factor investing but what all these approaches seem to share is a common methodology namely that one can screen the market using ‘filters’ of some sort that can produce a differentiated outcome. And what might that differentiated outcome look like? In simple terms the philosophical under pinning of these screening strategies involves one of three narratives. These are:
In truth most of the current marketing of funds focuses on the first (factor based investing) and the third (ESG or sustainable investing) but the rise of multi factor black box solutions also suggests that there is an untapped thirst for the second narrative based around some kind of magical, undiscovered alpha. Readers of this publication will know that there’s any number of quantitative studies that have sought to prove or disprove all of these narratives. I would suggest that you’ll probably find a paper that backs up whatever is your narrative, replete with convincing treasure troves of data.
A more philosophical approach might be needed, one that is I argue more reflexive in nature – and which ends up pushing investors back to the old way of investing, passively. What do I mean by this? My sense is that all three narratives listed above assume a fairly two-dimensional way of looking at markets, one which does not include a more nuanced take on agency and behaviour. We analyse fundamental data and then try and find some quantitively defined outcome. But this world view, based on a rational view of agency, does not necessarily account for the way in which markets are constantly adaptive.
Let me explain by reference to two examples. In our search for reducing risk by using quantitative measures we might encounter the law of unintended consequences. Past analysis suggests that a focus on quality stocks is a smart strategy. Thus, we market agents bid up the value of quality stocks. Valuation metrics become inflated, amidst crowded trades. These quality stocks fight to reserve their high margins but new competition – from the emerging markets – enter their marketplaces to capture the quality outcome. Debt levels rise at the big quality corporates (they’re nearly all investment grade and can thus borrow cheaply) and then investors become disappointed.
Over in ESG based investing another example might be that ethical types decide to avoid egregious oil and energy businesses who deny climate change. Large institutions disinvest but the managers of said firms choose to double down on their focus on profitability above all else in the evil hydro-carbons trade. Eventually these sin stocks start to outperform (think tobacco stocks) and awkward trustees on big institutional boards start to ask why they are on the wrong side of a performance trade. In extreme cases unscrupulous hedge funds start to short virtuous stocks and go long sin stocks.
These very simplistic examples assume that markets are complex and adaptive and that agents within said markets constantly tack to market mores and ways. We know the truth of this from the declining efficiency of alpha seeking strategies. An innovator says they’ve found a completely novel way of generating alpha through a screen. Everyone notices, and an arms race in intellectual property kicks off as everyone attempts to copy said quant strategy. Over a short period of time said advantage is arbitraged away. Causal relationships flash up and then fade away. Market agents constantly adapt.
If this all sounds strangely familiar, that’s because it is. I’ve been articulating a way of looking at investing that Andrew Lo from MIT has long advocated, namely the adaptive markets hypothesis which has five basic tenets:
The cynic might argue that this all sounds a bit obvious - what can investors do to acknowledge these ideas into a practical methodology? Rather like the first wave of behavioural economics insights, it is all compelling stuff but fundamentally unactionable.
Not so according to Lo. He thinks there are practical ways of building this reflexivity and adaptiveness into portfolios. According to Lo, “the first thing I would do is to identify and catalogue the different financial species — pension funds, hedge funds, mutual funds, banks, broker/dealers, insurance companies, and so on — and take an inventory of the size, growth rates, and other characteristics of each.”
This is I think a crucial insight and at its core it forces investors to understand the agents behind key flows/trends/trades/anomalies and their own motivated reasoning. Once identified, we can then begin to understand how – and why – they behave in the way they do and why anomalies bloom and then wither away. In this narrative we begin to understand that investors make decisions not always in a rational way but for emotional reasons. They are also agents of institutional capture i.e big pension fund investors almost have to buy Govies and investment grade debt because of regulatory requirements.
According to Andrew Lo, these ideas can built into portfolio strategies that “include dynamic factor models for measuring common exposures among investors’ holdings, where the factor loadings are time varying and capture shifts in the relative importance of factors over time….these tools also include interactive software platforms for measuring the preferences of investors on a regular basis, monitoring changes in their goals, desires, and constraints as their lives unfold and they change." 
But I would go one step further and push the adaptive markets hypothesis to what I think is its philosophical conclusion. I would suggest that for the vast majority of end investors the original passive idea is still the best way of looking at the world of investment. Investors, and their advisers, simply are not endowed with the tools – emotional and rational – to map out the constantly adaptive markets I’ve described, and more to the point, they should not bother trying. Just buy the market in a passive sense and concentrate instead on adapting those parts of investor behaviour we can control and more accurately predict – save more, and invest in our own personal capital.
The opinions expressed in this article are those of the author. They do not purport to reflect the opinions or views of EDHEC-Risk Institute