Why do most institutional investors, both active and passive, continue to rely on the efficient market hypothesis? Here’s another quote from Paul Woolley’s paper, Why are financial markets so inefficient and exploitative – and a suggested remedy:
Faith in the efficient markets has also underpinned many of the practices of investment professionals. The use of security indices as benchmarks for both passive and active investment implies a tacit assumption that indices constitute efficient portfolios. Risk analysis and diversification strategy are based on mean/variance analysis using market prices over the recent past even though these prices may have displayed wide dispersion around fair value. Investors who may have doubted the validity of efficient market theory and enjoyed exploiting the price anomalies for years, have nevertheless been using tools and policies based on the theories they disavow or disparage.
My guess: It’s an attempt to manage the principal and agent problem. How do we know if a fund manager is good? By comparing them to a benchmark and to other managers. How do we make sure they don’t do anything stupid? By imposing portfolio construction constraints to ensure a minimum amount of diversification. How do we make sure that they won’t experience a large amount of underperformance? We limit their tracking error.
And when we’re unhappy with the results, what do we do? We create a new allocation in our portfolio for hedge funds.
How about giving active managers a sensible degree of freedom to do the job that we hired them for?