平成２４年５月１０日
各位
社団法人

日本証券投資顧問業協会

CREATE－Research 社による投資理論に関する報告書

このたび CREATE-Research 社の CEO である Amin Rajan 教授が作成した”The Death of Common Sense”と題する報告書（英語）を、ホームページに掲載しました。同社は、英国の独立系のグローバルなコンサルティング会社であり、金融、航空宇宙、IT、石油、製薬、テレコム等の幅広い産業をカバーしています。
同報告書は、世界各国の 9 名の CIO から構成されている The 300 Club という組織の見方や考え方を取りまとめたものであり、今回は、2008 年の市場崩壊に際して、CAPM や効率市場仮説といった理論が機能しなかったことを結論付ける内容となっています。
資産運用業に携わる方々にとって役立つものとなれば幸甚です。

以上The Death of Common Sense:
How elegant theories contributed
to the 2008 market collapse
	Prof. Amin Rajan
CEO, CREATE-Researchamin.rajan@create-research.co.uk

1. Scene setting
The 300 Club believes that modern portfolio theory and practice are failing institutional
investors at a time when their depressed funding levels and high covenant risks require
smarter ways of investing.
Investor confidence is now at its lowest ebb in living memory. The scale of the losses
inflicted by the Lehman collapse in 2008 and the sovereign debt crisis in 2011 are
immediate causes, but confidence had been eroding over the last decade.
First and foremost, the buy-and-hold strategy was not working, as equities were
outperformed by bonds over a long period; second, nor was the barbelling approach, as
actual returns diverged markedly from expected returns for most asset classes; third, nor wasdiversification, as excessive leverage ramped up the correlation between historically lowly
correlated asset classes.

Views expressed here are those of theauthor, who is solely responsible for any
errors and omissions.

Content:
1. Scene setting1

2. How it all began2

3. A dangerous
comfort blanket

4

4. A bullet dodged

7

5. The momentof reckoning9

6. What’s all this got to dowith efficient markets?

11

7. What next?

13

These fault lines gave investing poor press after the unprecedented scale and speed of selloffs in 2008. The prevailing doom and gloom caused a herd-like rush into passive funds,
as armchair pundits projected the here-and-now into the future. Rational debate wasconspicuous by its absence. It is time for a sombre stock-take.
The 300 Club aims to up the ante by delivering dispassionate analyses of the problems that
our industry faces, and the actions that it needs to take. Accordingly, this is the first paper ina new series. It sets the scene for the subsequent papers.
It aims to:• Describe the modern portfolio theory which has profoundly influenced the thinking of
successive generations of investors and policy makers since the 1960s• Review the empirical evidence produced by independent experts to assess how modern
portfolio theory has stood the test of time
• Assess the role that modern portfolio theory played in the great financial crash of 2008
• Highlight the subject areas that need to be addressed, if a vibrant investment industry is
to emerge from the ashes of the recent meltdown.
Our narrative starts with Harry Markowitz, the pioneer of modern portfolio theory. His
famous paper on portfolio selection was a game changer [Markowitz, 1952]. Till then, there
was no cogent theory of investment: only rules of thumb and folklore. Investors of 1952
thought the same thoughts and talked the same language as investors a century previously.

Speed-Read
Investor confidence is
now at its lowest ebb inliving memory. Modern
portfolio theory bears some
responsibility.
This paper describes how
it all came about. It also
sets the scene for otherpapers in this series fromthe 300 Club.

2|

The 300 Club | The Death of Common Sense | April 2012

Markowitz was the first to make risk the centrepiece of portfolio management. The noveltyof his approach was summed up by his famous insight:“Investing is a bet on an unknown future… you have to think about risk as well as return”.
He thus inspired the intellectual origin of the two concepts that have since dominated theburgeoning literature on portfolio theory as we know it today: the capital asset pricing model(CAPM) and the efficient markets hypothesis (EMH).
In the CAPM, an investor selects a portfolio at a given time t which produces a return attime t+1. The model assumes that investors are risk averse. When selecting their portfolios,
they care only about the mean and variance of their one-period investment return. The
model is also called the mean-variance model since investors seek to minimise the variance of
portfolio return, given expected return; and maximise the expected return, given variance.
Before long, two other related concepts were invented in the investment landscape: efficient
markets and active management. It was argued that by factoring in all known information
into prevailing stock prices, an efficient market bears out all the predictions of the CAPM.
Thus, based on a priori reasoning, this argument also inferred that active management adds
no value: in an efficient market nobody has an information advantage.
The edifice of modern financial theory is mainly constructed around CAPM and the EMH.
We review the evidence on each in order to show how they contributed to the current
financial crisis.
Our review is deliberately detailed: it aims to show how the evolution of the theory overtime has side-tracked into trivia and inadvertently missed the big picture of how the financial
markets really work.

The theory started withthe sound idea thatinvesting is a bet on
an unknown future.

But its subsequentevolution sidetracked
into trivia and missed thebig picture understandingof how the financial
markets work…

…while also giving birth
to intellectual twins.

2. How it all began
The CAPM originated from the work of the Nobel Laureate William Sharpe [1970]. He
advanced the idea that each investment contains two distinct risks:• Systemic risks: as the name implies, these are all-pervasive market risks that cannot bediversified away. They affect investor sentiment directly and market volatility indirectly.
Interest rates, recessions, inflation and wars are examples of factors that affect the price ofall securities, notwithstanding their business fundamentals. Diversification is no answer tosystemic risks that affect all assets indiscriminately.
• Idiosyncratic risks: these risks, in contrast, are specific to individual stock and can bediversified away as an investor increases the number of stocks in his/her portfolio. As
the name implies, it represents the component of a stock’s return that is uncorrelatedwith general market movements. The only reason why an investor should earn more, on
average, by investing in one stock rather than another is that one is riskier than the other.
The CAPM’s starting point is the risk-free rate – typically a yield on a government bond: itis the minimum return that investors expect. However, it goes on to argue that investors inequities also demand an added premium to compensate them for taking the extra risk. Thisrisk premium is derived by calculating the expected return from the market as a whole lessthe risk-free rate.
On this argument, much of the variation in expected return comes from market movements
as a whole: idiosyncratic risks are negligible. Therefore, by implication, active management
cannot add value, it is just noise.

The first was the Capital
Asset Pricing Model.
By making various
assumptions, it concluded
that much of the variation
in investment returns
comes from market
movements.

Subsequent tests showedthat CAPM omitted
numerous other factorsthat influence returns…

The 300 Club | The Death of Common Sense | April 2012|3

In the academic world, CAPM rode high for the best part of two decades with early tests
creating a consensus that the model is a good description of the expected returns. Coupledwith the model’s simplicity and intuitive appeal, these tests pushed the CAPM to theforefront of financial theory of markets [Fama and French, 2004].
However, these authors also show that since the late 1970s, there has been mounting
evidence that the variation in expected return is unrelated to market beta alone. Theirexhaustive summary of various studies shows that certain factors ignored by CAPM have asignificant role in influencing future returns.
They include:• Price-earnings ratios• Company size as measured by market capitalisation• Debt-equity ratios that measure leverage• Book-to-market equity ratios.

…such as businessfundamentals likeearnings, company size,
debt and so on.

Fama and French went on to consider whether these seemingly ‘spurious’ results might be
the result of data dredging: publication-hungry researchers scouring the same US data on
returns and unearthing contradictions that occur in specific samples by chance. However,they dismissed this possibility as these additional factors were also identified as significant inother independent studies, using Japanese and European data.
These other studies also show that CAPM ignores investors’ behavioural biases, they often
over-extrapolate past performance resulting in stock prices that are too high for growthfirms and too low for distressed firms. When the over-reactions are eventually corrected,
value stocks tended to end up with high returns and growth stocks with low returns.
This is a far cry from CAPM’s key premise that investors care only about the mean andvariance of distributions of one-period portfolio returns. In two previous papers, Fama andFrench [1993, 1996] refine the original specification of the CAPM and include two otherfactors: company size and book-to-market equity ratios.
Later refinements included two more factors. The first was the momentum effect: stocks
that do well relative to the market over the previous three to twelve months tend tocontinue to do well for the next few months [Carhart, 1997]. The second concerned cash
flows: stocks that do well relatively also have high expected cash flows.
These and other refinements are a matter of detail. The substantive argument is that
CAPM’s two-point inference on active management has been sorely challenged. Namely,that expected returns are solely influenced by market beta and it is impossible to beat themarket by developing special insights into company-related factors. Evidence on boththese points is weak, at best. Yet, the proponents of CAPM still continue to reject active
management by its a priori assumptions.
For them, the centrality of trade-off between risk and expected return continues to infuse
all investment decisions. Even alpha is defined as returns above or below what the CAPM
predicts. The twin notions, that the market is hard to beat and investors are rational, arenow conventional wisdom, even among those who declare they know how to outperform.
As Fama and French conclude [2004]:“The CAPM, like Markowitz’s portfolio model on which it is built, is nevertheless a theoretical
tour de force. Despite its seductive simplicity, the CAPM’s empirical problems invalidate its
applications.”

Yet, CAPM remained atheoretical tour de force
because It was difficult
to understand how
markets worked without
first taking CAPM into
account.

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The 300 Club | The Death of Common Sense | April 2012

Bernstein [2007] sums it up succinctly by stating that the situation is identical to what
Louis Menand, the Pulitzer Prize-winner, had to say about Freud’s famous tract, Civilisation
and Its Discontents:“The grounds have been entirely eroded for whatever authority it once enjoyed as an ultimate
account of the way things are, but we can no longer understand the way things are without
taking it into account.”
Much the same observation can be made about CAPM’s intellectual twin: the efficient
markets hypothesis, a deceptively simple notion that has become a lightning rod for its
disciples and opponents alike.

3. A dangerous comfort blanket
Despite numerous modifications, the basic thrust of the EMH has not changed much since
the Nobel Laureate Paul Samuelson first proposed it:• Individual investors form expectations rationally• Expectations are based on all available information

In the meantime,
CAPM’s intellectual
twin, the efficient markets
hypothesis, was gaining
traction.

EMH argued thatmarkets are efficientbecause they factor in all
known information when
pricing securities. They
follow a random walk.

• Markets aggregate information efficiently and• Equilibrium prices incorporate all information.
In a seminal article [Samuelson, 1965], he argued that prices fully reflect all available
information. In an efficient market, price changes cannot be predicted with any realistic
degree of accuracy, since they already incorporate the information and expectations of all
market participants.

So, active management
is just ‘noise’: it can neveroutperform the markets.

The underlying idea is that in a large, active marketplace for publicly traded securities,
vigorous competition among thousands of investors will drive speculative profits to zero. To
the extent that speculative trading is costly, speculation must be a loser’s game.
On this argument, passives are bound to beat actives that seek to exploit mispriced assets
relative to a risk-adjusted benchmark, since the invisible hand of the market works fasterthan any single investor.
Samuelson’s concept of informational efficiency has a Zen-like counterintuitive flavour [Lo,2004]. The more efficient the market, the more random are the price changes generated by
it. In the extreme case of efficiency, price changes are totally random.
The implications are clear. If prices are unforeseeable, then:• Their future direction is random• They follow a bell curve distribution• They nullify active management.
Until the EMH was subjected to a battery of empirical tests, the received wisdom was
simple: when new information emerges, the news spreads very quickly and is instantly
incorporated into the price of securities.
Hence, neither technical analysis (the study of past prices to predict future prices) nor
fundamental analysis (study of company-specific data) can enable investors to identify‘undervalued’ stocks and achieve returns greater than those that could be obtained by arandomly selected portfolio of individual stocks.

This idea has spawned
today’s passive industry.
Earliest indices were
not created to measuremanger performance but
to provide a representative
outcome for the market
as a whole. The index isa market proxy, not an
investment idea.

The 300 Club | The Death of Common Sense | April 2012|5

Unsurprisingly, the hypothesis is linked with the concept of a ‘random walk’ in the financeliterature to caricature a price series where all subsequent price changes display arbitrary
departures from previous prices.
On this argument, the price of a financial asset always reflects all available information
relevant to its value. Deviations from equilibrium value cannot last long. Investors withinformation on under-valued assets will drive up their prices and make money in the shortterm. Beating the market in the long run is a fool’s game. Markets are omnipotent. Active
management doesn’t work.
This belief has spawned today’s $4 trillion index fund industry. While the history of the
Dow Jones Industrial Average dates back to 1896, it is worth emphasizing that this index
was simply a market proxy, not an investment idea. The earliest indices were not createdto evaluate manager performance, but to provide a representative outcome for the stock
market as a whole.

Before the crisis, however,there were growing doubts
about the validity of
the EMH.

However, as technology developed to recreate market portfolios and observers notedthat fewer managers were beating their benchmarks, enterprising asset managers saw anopportunity to deliver market representative returns at rock-bottom costs. As indicesproliferated, the EMH became a de facto investment strategy in its own right [Sahai andPoor, 2011].
So widespread was the acceptance of the EMH that another Nobel Laureate [William
Sharpe, 1991], had no hesitation in brandishing its detractors as being wholly economicalwith the truth:“Properly measured, the average actively managed dollar must underperform the average passively
managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of
improper measurement.”
But with the 2008 market meltdown, the knives were out.
Writing for The Washington Post in June 2009, financial journalist and best-selling author
Roger Lowenstein pulled no punches:“The upside of the current Great Recession is that it could drive a stake through the heart of theacademic nostrum known as the efficient market hypothesis.”
In a similar vein, writing in his quarterly letter in January 2009, Jeremy Grantham, a highly
respected money manager at GMO, said:“The incredibly inaccurate efficient market theory [caused] a lethally dangerous combination ofasset bubbles, lax controls, pernicious incentives and wickedly complicated instruments that led
to our current plight.”
However, long before then, academic researchers had been training their guns on the
EMH. Notably, however, none of them anticipated the catastrophic outcomes narrated by
Lowenstein and Grantham. Instead, they were much more concerned about the nitty-grittyof improving the explanatory powers of the theory at the margin.
Hardly anyone questioned its foundations. This was an era in which the ‘rational
expectations’ school of thought, pioneered by economists at the University of Chicago, wasin rapid ascendancy. It believed in the primacy of markets as an article of faith: markets
knew how to value resources and allocate them most efficiently through an impartial androbust price mechanism. The invisible hand of the market, so the argument ran, knew
better than the visible boot of the state.

But its proponents
maintained that any
evidence that runs against
it has to be guilty of
improper measurement…

...because only markets
know how to value
resources and allocate
them most efficiently.

Recent critics argue that
this blind faith caused
a lethally dangerous
combination of asset
bubbles, pernicious
incentives andcomplicated instrumentsthat led to our current
plight.

6|

The 300 Club | The Death of Common Sense | April 2012

So, the new research focused on the narrow issue of whether past price changes could
predict future price changes. They did find weak evidence that the past foretold the future.
But these studies did not address a number of critical questions:• How is the information generated before it impacts market prices?
• What mechanism causes the information to be reflected in prices?
• What is the incentive for anyone to generate the information?
• Why would anybody do any research on a company, if trading on information is
unprofitable?
• If nobody collects any information, how can prices still reflect all the information?
• Most importantly, are markets ‘efficient’ in the sense that they can price assets correctly?

Before the current crisis,
the proponents of the
EMH had in fact begun
to accept a limited scopefor active management

These questions led to a number of refinements of the original idea propoundedby Samuelson.
Grossman and Stiglitz [1976] focused on information acquisition. They showed that those
who invest in research are rewarded through speculative profits so that they at least recoup
the cost of that activity. By being the first mover of the ‘invisible hand’, they drive prices
towards their fair economic value. Thus, by extension, the authors envisaged the role ofactive management backed by superior resources and skills.
In a parallel tract, there also emerged the arbitrage pricing theory [Ross, 1976], whichshowed that the activity of arbitrageurs would naturally drive the expected returns to a levelthat correctly reflects the risk-return trade-off of any asset.
The idea was further refined in a paper that was based on the old adage from John Maynard
Keynes that ‘markets stay irrational longer than you can stay solvent’ [Schleifer and Vishny,
1997]. They showed that high financing risk forces arbitrageurs to be cautious about
exploiting mispricing. The outcome can be calamitous, if this risk is ignored, as happened in
the case of Long-Term Capital Management.
Its highly leveraged bet on the convergence of US vs European and Japanese bond yieldfollowing the Asian currency crisis was sound and the convergence did actually happen.
However, in the meantime, the leverage bankrupted LTCM and created a systemic crisis
in 1998.
Over time, empirical studies came to acknowledge that active management can, and does,
regularly exploit the deviations from equilibrium prices via specialised knowledge, lower
trading costs, low management fees and a financing structure that rides out price anomalies
persisting over a long period.
Indeed, if everybody shared the same opinion, nobody would trade [Black, 1986].
Differences in opinion create inefficiency and this in turn is the basis for trading. Earnings
from active management are a reward for informed investors for identifying and exploiting
mispricing created by other investors. But that is not all.
Researchers argued that the segmentation of markets and investors can have an impact
on the market values of securities, on top of their business fundamentals [Barberis, Schleiferand Wurgler, 2003]. Investors are shown to pigeon-hole securities – by, for example,
geography, index or size – due to information limitations, trading restrictions andtrading costs.
However, the reader who wades through this and other studies should expect a long hardslog, with little likelihood of emerging on the far side appreciably enlightened.

…but the resulting
debate generated moreheat than light.

The 300 Club | The Death of Common Sense | April 2012

All they will discover is that it is nigh on impossible to test the two key propositions of
the EMH: (a) markets are efficient since they incorporate all available information and(b) markets provide a fair valuation of securities. Neither of these propositions can be
independently tested via the conventional econometric methods. Hence the EMH cannever be rejected [Campbell, Lo, and MacKinlay, 1997].
While a number of factors – ‘anomalies’ – have been identified as delivering higher returns
over time that cannot be explained by the EMH, there is no consensus on whether thesefactors reflect the existence of an inefficient market or the dynamic nature of risks that nomodel can explain.
The sceptics, as a result, go for the jugular: anomalies mean that the whole paradigmof rational expectations that reigned supreme for nearly fifty years is no more than an
ideological aspiration about how markets ought to work under the tenets of neo-classicaleconomics. The crash-landing of its two cherished idols – CAPM and EMH – in 2008shows all too well that they were as remote from the complexities of markets as the man on
the moon.

|7

Yet, a tacit volte face
was evident when it
was conceded that the
EMH did not mean thatmarkets were ‘efficient’in the sense they could
price assets correctly.
All it meant was thatprices reflect all known
information.

Writing in The New York Times Magazine in September 2009, another Nobel Laureate, Paul
Krugman, argued that Chicago School free market theorists “mistook beauty…. for truth”.
The synthetic outrage provoked by the article generated more heat than light [Frydman andGoldberg, 2011].
The advocates of the EMH countered that it is still alive and well except for periodic
distortions. The stock market is a voting mechanism in the short term, but a weighing
mechanism in the long term. True value will win out in the end.
They also contend that the EMH never stated that the markets are ‘efficient’ in the sense they
can price assets correctly: all it said was that prices reflect all known information. It does not
say that this information is valued correctly in any sense: prices merely reflect the current
consensus of the market without preventing market changes on a whim. In short, markets
can be inefficient and inaccurate.
This volte-face is all the more remarkable for its tacit subtlety. For belief continues to reign
supreme over reason: reality is not allowed to obscure the theory! No wonder the average
investor is bewildered. No wonder Lowenstein and Grantham pull no punches.
For now, it is worth restating the measured conclusion of the most detailed review presented
in a recent landmark report commissioned by the Norwegian Government Pension Fund[Ang, Goetzmann, and Scherfer 2009];“The balance between indexation and active management is a choice variable for which the
optimum depends on general beliefs about the existence and potential of manager skill, thepricing opportunities afforded within a given market, the time preferences and risk aversion of
the investor, and the expertise and incentive contract of the specific manager.”

The most dispassionate
study done so far inferredthat the EMH leapt fromunwarranted assumptions
to pre-conceived
conclusions.

Translation: the EMH leapt from unwarranted assumptions to pre-conceived conclusions.

4. A bullet dodged
The original attempts to check the randomness of stock prices looked at whether the way a
price behaved in the past is any guide to how it will behave in the future. They showed thatstock prices did not behave as random walks. Future price changes were influenced by thepast movements: market has a memory, after all.

It also confirmed thatstock prices do not behave
as random walks, as
postulated by EMH.

8|

The 300 Club | The Death of Common Sense | April 2012

To economists and psychologists engaged in the field of behavioural finance, such short run
momentums are consistent with the “bandwagon effect”. The famous example of that was
the psychological contagion leading to irrational exuberance with the tech bubble in the
1990s [Shiller, 2001].
The behaviouralists acknowledge the inherent fallibility of mortal investors. To them,
humans are highly imperfect organisms, given to bouts of greed and fear. They are
impatient; they make analytical errors, suffer from bad data interpretation and overrate theirabilities. Moreover, they are hard-wired for self deception, plain ad hocery, and faulty logic,
contrary to the premises of the EMH. They are not rational, calculating machines, without
systematic biases, whose behaviours can be predicted by mathematical models.
The most memorable indictment from this behaviourial perspective came from
Shiller [1981]:“Just because markets are unpredictable doesn’t mean they are efficient. The leap in this logic was
one of the most remarkable errors in the history of economic thought.”
Before then, however, the new behavioural edifice had started to expose fault lines in the
EMH, since the landmark publication of Prospect Theory [Kahneman and Tversky, 1979].
It accepts that there is often a reasonable balance between different types of investors in
the market and deviations in valuation are often corrected. But look under the bonnet
and you’ll find a whole bunch of behavioural cognitive biases ticking away – sometimes
cancelling each other out, most times not. These biases reflect imperfections in theirperceptions of reality.
In finance, four biases are most common:• Mental accounting: dividends are perceived as additions to income; capital gains are not• Biased expectations: people tend to be overconfident in their predictions of the future• Reference dependence: investment decisions are affected by an investor’s reference point
which tends to be arbitrary

Indeed, new advances
in behavioural financeshowed that markets sufferfrom ‘bandwagon’ effects
that can be contagious.

But such advances werebrushed aside at the time
- so powerful was the voiceof the old guard.

• Representativeness heuristic: investors mistake good companies for good stocks, notrealising that their stock is usually already fairly valued, leaving little upside potential.
If the new behavioural finance is closer to reality than the old EMH paradigm of rational,
calculating utility-balancing economic man, why has it failed to make major inroads into
conventional thinking? There are two reasons.
The first reason is the power of the old guard, protecting the citadel for free market
economics. It was the scientist Max Plank who showed that science advances “one funeral ata time”. It requires the old, controlling generation to die before new ideas that threaten theirconception can take hold.
The second reason is that the EMH appears to work a lot of the time and then suddenly
blows up. It is analogous to the relationship between Newton’s laws of gravity and Einstein’s
theory of relativity. The former approximates the latter so long as the odd stuff about the
speed of light and anti-gravity are taken out.
The problem seems to arise from the frequency of events in markets. High frequency events
tend to follow the predictions of the EMH. If asset prices tend to deviate overly from anaccepted norm, then the normal mechanism of the market brings them back in line.
On the other hand, there are also low frequency events that do not follow the EMH.
When they occur, efficient market strategies can be disastrous, as deviations from sensible
valuations turn explosive rather than self-correcting. Rational economic theories can’t
explain such events that stem largely from subconscious investor psychology.

Besides, the EMH
appeared to work a lot of
the time, then, it blew up– much like Newton’s lawsof gravity - when facedwith the notions of anti
gravity and speed of light.

The 300 Club | The Death of Common Sense | April 2012|9

Finally, for all its fresh insights, the new behavioural finance can tell us why things go
horribly wrong but not when. Not surprisingly, Samuelson admired Kahneman but
considered much of the work in the behavioural finance “a lot of noise” [Bernstein, 2007].
He doubted if one could make money out of it. To him, most investors do not evenunderstand how to capitalise on behavioural anomalies even if they are sceptics about
efficiency and fans of behavioural finance. However, he did not address the bigger issue:
namely, to what extent can such behavioural biases cause market contagion with disastrous
consequences for the world economy?
Research attention remained firmly focused on the nuts-and-bolts of the EMH. On
the one hand, some proponents of behavioural finance recognise its limitations, as speltout by Samuelson. On the other hand, the proponents of EMH started to factor in the
behavioural effects.
This synthesis is clear from the emergence of The Adaptive Markets Hypothesis [Lo, 2004].
It argues that investors are hardly capable of the kind of utility optimisation assumed in the
EMH. Since optimisation is costly and since humans are limited in their computational
abilities, they engage in ‘satisficing’: making choices that are satisfactory, not optimal.
Such decisions are reached not analytically, but through trial and error that enables one todevelop simple rules of thumb that evolve into heuristics over time.

So pervasive was the
hypnotic appeal of the
EMH that researchpre-2008 did not evenconsider the bigger
issue: namely, how the
bandwagon mentality
in a world awash withliquidity could cause
disastrous consequences
for the global economy.

Thus, when the environment changes, the heuristics of the old environment are notnecessarily suited to the needs of the new. The mismatch gives rise to behavioural biases:
actions seem ill-advised in the context in which they are taken.
However, according to Lo, the new paradigm of AMH is still in its infancy and requires a
great deal more empirical testing before it dislodges the EMH. He admits that:“The internal consistency and logical elegance of the EMH framework are almost hypnotic, and
it is all too easy to forget that the EMH is merely a figment of our imagination, meant to serveas an approximation – and not always a terribly accurate one – to a far more complex reality.
Unlike the law of gravity and the theory of special relativity, there are no immutable laws ofnature from which the EMH has been derived.”
The implications are clear. Neither the CAPM nor the EMH have the necessary empiricalcredence; quite the reverse. Yet, they remained firmly anchored in the investor psyche andpolicy thinking in the West – at least until the 2008 market meltdown. It reminded us all
too painfully that [Derman, 2011]:“CAPM is a useful way of thinking about a model world that is, quite often, far from the world
we live in.”5. The moment of reckoning
In hindsight, it beggars belief that the sub-prime mortgage boom in the US lasted for as
long as it did.
The Federal Reserve could not foresee a concealed time bomb. Nor did it have the inklingthat any sub-prime crisis in the US would soon tip into a global disaster by the new markto-market rules introduced after 2004. So keen it was to sustain the economic recovery in
the 1990s that at every whiff of a market downturn, fresh liquidity was pumped into thesystem. With the banking system awash with cash, product innovation proliferated.

Despite strong evidence tothe contrary, both CAPM
and EMH remained
firmly anchored in theinvestor psyche andpolicy thinking...

10 |The 300 Club | The Death of Common Sense | April 2012

Sub-prime loans became a ready outlet, once they were sliced, diced and repackaged to create
the magic dust. Authorities believed that the efficiency of the markets would ensure their fairvaluation and attract willing buyers around the world for these freshly minted securitised
products – many with (bogus) triple-A rating. Also by spreading their risks across the global
investment community, their use of derivatives would pre-empt any systemic risks. Alan
Greenspan, no less, was emphatic on the merits of this financial engineering [1997]:

Policy makers did not
see the 2008 meltdown
coming when…

“The use of a growing array of derivatives and the related application of more sophisticatedmethods of measuring and managing risk are key factors underpinning the enhanced resilienceof our largest financial institutions. … As a result, not only have individual financial
institutions become less vulnerable to shocks from underlying risk factors, but also the financial
system as a whole has become more stable.”…15 years of asset
gains were wiped out
in 15 months.

The rest is history. No wonder, today’s investors fall into two camps: the shocked and thedismayed. Indiscriminately, like a tsunami, the 2008 sub-prime crisis wiped out some $15
trillion in asset values, hitting every asset class, every market, every geography and every
client segment: 15 years of capital gains were wiped out in 15 months.
Yet, in May 2007, barely three months before the crisis unfolded, Ben Bernanke couldn’t see
a phenomenon of this magnitude coming, when he stated in a public speech in May 2007:“We do not expect significant spill-over from the sub-prime market to the rest of the economy orto the financial system.”
Nor did Gordon Brown, for that matter. In his June 2007 Mansion House speech he said:“Everyone needs to follow the City’s great example and emulate this high value-added talentdriven industry. Thanks to its remarkable achievement, we have the huge privilege to live in an
era that history will record as the beginning of a Golden Age.”Of the 20 biggest daily upswings in the S&P 500 since 1980, 10 have occurred in the last
five years. Likewise, of the 20 biggest downswings, 13 have taken place in the last 5 years.
Rarely have the stock markets been so wild and moved so little, until early 2012. With too
many wild variables, investing has become a loser’s game.

To their cost, investors
have since learnt that theworld of investing can bea hall of mirrors, where
what you see is not as it is.

This is a far cry from the heady days of the 1990s when the unrelenting chase for relative
returns delivered double digit performance year after year until the ensuing crash in March
2000. It was a defining moment. Investors discovered that index hugging could not buy
groceries in a bear market; nor could it prevent an unprecedented funding shortfall in
defined benefit pension plans worldwide. Thus, uncorrelated absolute returns became the
new mantra.
Some 30 new product sets, asset allocation tools and hedging techniques were duly
adopted [Rajan, 2011]. They aimed to control risk and boost returns irrespective of market
conditions – only to be overwhelmed by the crash of 2008.
That episode showed that the world of investing can be a hall of mirrors: what you see is
not as it is. Securitised mortgages in the US are just one example. The other is a raft ofstructured products that were subsequently hammered by the collateral damage from thecollapse of Lehman Brothers and AIG. But that is not all.
In the heady days of the 2000s, there was a growing belief that the economies of the Eastand the West had significantly decoupled to the point where a market crisis could becontained. Yet, China and Russia notched up the biggest market falls in the immediate
aftermath of the Lehman collapse. Globalisation had created greater economic connectivity
and contagion susceptibility – concepts that were wholly alien to the EMH.

They lost money inevery asset class they
were advised to follow
by equating risk
with volatility.

The 300 Club | The Death of Common Sense | April 2012

They are hard to model in a world where technology has amplified investor mood swingsand compressed decision spans from calendar time to real-time. Nearly 65% of daily
movements in key market indices are now driven by ‘noise’ rather than ‘signal’. Politics, noteconomics, drives the markets. Also, high frequency trading reinforces the periodic bouts ofrisk-on/risk-off that are unconnected to corporate fundamentals, a far cry from the selfcorrecting mechanisms of the efficient markets.
In hindsight, investors have learnt that they were not managing risk, they were managing
uncertainty. One relies on known probabilities of expected returns, the second on pureguesswork. As one large pension plan participating in the 2011 CREATE-Research survey
observed,| 11

It is all too clear that,far from acting onrational signals as EMH
postulated, markets canalso be driven by ‘noise’that is far removed frombusiness fundamentals.

“We’ve lost money in every asset class we were advised to follow in the last decade”.
Few policy makers and their economists saw the bear markets coming; few detected thetime bomb concealed in cheap money; few understood the unintended consequences of themark-to-market rules; few expected the asset class correlation to go through the roof: few
challenged the validity of the bar belling model. Long conditioned to viewing the investment
landscape through the prism of EMH, they failed to see that investing had become ever morenuanced in the face of systemic forces akin to the Black Swan [Taleb, 2007].
In retrospect, the 2000-02 equity crash was a defining moment in global fund management.
It set off a chain reaction whose cumulative impacts were hard to foresee. As millions lost
billions, the old ways of investing fell into dispute. Nor could the hype of equity risk premiumor benchmark hugging stop a severe shortfall in defined benefit pension plans worldwide.
So, they switched from relative to absolute returns, in what promised to be an era of low
nominal returns. This decisive shift coincided with the most benign conditions in credit
markets in living memory. These conditions served to perpetuate the myth that absolute
returns were not only desirable but also deliverable, thanks to the arrival of the ‘new mastersof universe’ who had suddenly rediscovered the skills that lay fallow in the bygone era of
relative returns, when chasing alpha was like looking for a needle in a haystack.
In the brave new world of absolute returns, this new breed of managers overly relied on theuse of leverage, shorting and derivatives in their freshly minted ‘go anywhere’ type strategies.
Risk was stacked up like a wedding cake. Like alchemy and quack medicine, the prevailingrisk models thrived on the investors’ wish to believe in impossible things. The advice from aleading thinker of the day was largely ignored [Scholes, 2005]:“We make models to abstract reality. But there is a meta-model beyond the model that assures
us that the model will eventually fail. Models fail because they fail to incorporate the interrelationships that exist in the real world.”

6. What’s all this got to do with efficient markets?
First, it helped to cultivate the belief that markets are always right and mean reversion
towards fundamental values is the norm. A new lingo was created which, in hindsight,
used clever words to conceal longstanding problems. Policy makers, especially in the UK
and the US , were seduced into believing either that bubbles never happened, or if they
did there was no hope that central banks could spot them and intervene. Evidently, they
believed that markets have their own self-correcting fair-value dynamic. The only thing that
central banks can do is to mop up the periodic mess afterwards. That thinking lay behindWith hindsight, many of
the historical investment
conventions didn’t work in
the last decade when risk
failed to generate returns.

Investors discovered thatthey were not managing
risk, they were managing
uncertainty.

12 |The 300 Club | The Death of Common Sense | April 2012

the two savage bear markets of the last decade. It also lay behind the whole mark-to-market
accounting edifice introduced in 2004 that rests on the view that only markets can provide‘fair’ valuations at all times. Arguably, that edifice turned the US sub-prime crisis into a
global disaster, when the value of all securitised assets dropped like a stone, irrespective of
their intrinsic worth.
Second, it also turned investing from art to science; from craft to industrialisation; from
judgment calls to mechanical formulas. Much of the innovations – e.g. derivatives, shorting,leverage, portable alpha, high frequency trading – were justified on the grounds that the
only way to beat the markets was to create ever more clever mouse traps. More often
than not, they have aimed to extract value where there is none. Systemic risks, productcomplexity and higher charges have been the main outcomes.
Third, the EMH fostered complacency amongst policy makers and investors alike. Mostof them did not realise that, under the froth of the booming markets in the period 200208, serious fault lines were developing in the investment landscape in response to megaforces like the globalisation of markets, the impact of revolutionary technologies, andthe unintended consequences of regulatory changes – to name but a few. Via mounting
anomalies, caused by periodic bouts of dislocations, these forces were progressively eroding
the twin pillars of asset allocation: equity risk premium and asset class diversification.
The anomalies in question arose due to: the ad hoc manner in which markets react toinformation; the unstructured means by which markets price a given asset; and the
behavioural biases of investors who continue to use the old heuristics for new situations.
The anomalies have multiplied as markets have gone from: local to global; calendar time toreal time; clear ‘signal’ to loud ‘noise’; buy-and-hold investing to opportunistic investing;and asset management to liability optimisation.
Last, but not least, the ‘industrialisation’ of investing has, in turn, depersonalised relations
between investors and their asset managers. Unlike their physical counterparts, likecars and computers, investment products do not have a definable shelf life, they do notdeliver predictable outcomes, they cannot be pre-tested in a lab, and they do not carrya fit-for-purpose certificate. For good returns, what matters most are timing and market
environment. These require a far higher degree of engagement between investors andtheir managers than has been the case over the past 20 years where dis-intermediation has
become ever more pronounced [Rajan 2012].
For asset managers, it is essential to:• Understand their clients’ dreams and nightmares• Solicit new ideas by tapping into clients’ investment expertise• Manage expectations in what can and can’t be delivered• Minimise ‘wrong time’ risks in buying and selling• Communicate bespoke research that addresses unique issues to clients• Highlight proactive buying opportunities in periods of big price dislocations.

Most of them did not
realise that, under thefroth of the booming
markets in the period
2002-08, serious fault
lines were developing in
the investment landscapein response to …

…mega forces likethe globalisation ofmarkets, the impactof revolutionary
technologies, and theunintended consequencesof de-regulation in theprevious two decades.

To make matters worse,
indirectly, the EMH waspartly responsible forturning investing fromart to science, from craft
to industrialisation,from judgment calls tomechanical formulas.

It is all too clear that,far from acting onrational signals as EMH
postulated, markets canalso be driven by ‘noise’that is far removed frombusiness fundamentals.

For investors, it is essential to:• Seek better alignment of interests via common beliefs and time horizons• Obtain a second opinion on their asset allocation and correlation risks• Gain deeper insights into what works at different stages of market cycle• Develop the mental agility to capitalise on periodic market dislocations• Minimise behavioural biases and herd instinct provoked by periodic volatility• Understand the ‘health warnings’ that are usually lost in the fine print of legal agreements.

In hindsight, many of
the historical investment
conventions didn’t workin the last decade
when risk failed togenerate returns.

The 300 Club | The Death of Common Sense | April 2012| 13

7. What next?
Our main conclusion is that neither the CAPM nor the EMH have much empiricalsupport. They work until they don’t work. Both have undergone significant refinements
to the point where their much-publicised inferences – that markets are efficient and active
management does not work – are no longer tenable.

In sum, the events of
the last four years havediscredited the modern
financial theory.

Yet, they have reigned supreme for the best part of half a century, having a profoundinfluence on the psyche of financial investors, policy makers and the investment industry.
It is probably too far-fetched to single them out as the key culprits in the current crisis.
They are merely ingredients in a rich stew of financial irresponsibility, political ineptitude,
lax regulation and perverse incentives. Besides, the world of investing is too complex for a
few naïve ideas to bring it to its knees.
It is equally hard to underestimate their influence on the forces that have brought us towhere we are today. They promoted a world view detached from the on-the-ground reality.
For a long time, they rode on the back of the strong pro-market anti-regulation sentimentunleashed by the Thatcher-Reagan era in which faith mattered more than facts.
Either way, this paper has had the limited goal to describe how modern financial theory has
evolved and how it has been linked to the current crisis. As such, its tone and content havebeen deliberately retrospective.
Subsequent papers in the 300 Club series will focus on some of the challenges highlighted
in the last two sections and the responses they require from governments, investors and asset
managers. Areas that will receive special attention are dynamic asset allocation, manager
selection, principal-agency relationship and client engagement.

Further papers in thisseries will highlight areas
where fresh thinking isneeded, if today’s investors
are to have a fair deal.

14 |The 300 Club | The Death of Common Sense | April 2012

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The 300 Club | The Death of Common Sense | April 2012

| 15

The 300 ClubThe 300 Club is a group of leading investment professionals from acrossthe globe who have joined together to respond to an urgent need to raise
uncomfortable and fundamental questions about the very foundations of
the investment industry and investing. The mission of the 300 Club is toraise awareness about the potential impact of current market thinking andbehaviours, and to call for immediate action.
Current economic and investment trends will change the investing landscapeover the next two decades and we are at a crisis point which presents huge risks
to investors, according to the 300 Club. Moreover, the 300 Club believes thatcurrent financial and investment theory and practice run the risk of failinginvestors at their time of greatest need.

Contact us
For further information about the 300 Club contact our Media Team:
Asmita Kapadia+44 (0) 20 7680 2120
asmita.kapadia@the300club.org
Jean Dumas+44 (0) 20 7680 2152
jean.dumas@the300club.org
The views and opinions contained herein are individual views held by those of the 300 Club.
The information herein is believed to be reliable but the 300 Club does not warrant its completenessor accuracy. No responsibility can be accepted for errors of fact or opinion. This material is notintended to provide and should not be relied on for accounting, legal or tax advice, or investment
recommendations. This document is published solely for informational purposes and is not to beconstrued as a solicitation or an offer to buy or sell any securities or related financial instruments.
Although the 300 Club believes that its expectations and the information in this document werebased upon reasonable assumptions at the time when they were made, it can give no assurance thatthose expectations will be achieved or that the actual results will be as set out in this document.
The 300 Club undertakes no obligation to publicly update or revise any forward-looking
information or statements.