Portfolio Performance Measurement and Benchmarking by Jon A. Christopherson, David R. Cariño, and Wayne E. Ferson (McGraw-Hill, 2009) is a welcome addition to the literature on investment management. Although its intended audience is portfolio managers—institutional investors and hedge fund managers, the individual investor with basic math and statistics skills can profit from it as well. In fact, I intend to mine the book for useful nuggets now and again on this blog because the authors have done a masterful job of synthesizing research on performance measurement and their original work on benchmark construction is both thorough and enlightening. (Two of the authors are research fellows at Russell Investments; the third is an academic.)
Today I want to focus on the paradox of the efficient market because the authors offer an interesting twist on it. Basically the paradox claims that the efficient market hypothesis is true only if enough investors believe it to be false. If everyone believed in market efficiency no one would try to discover inefficiencies. “In such a world, price changes would slow to a crawl or cease because there would be no one who would believe that it is wise or prudent to pay anything other than the market price.” New information would not be incorporated into a stock’s price, so the market would become less responsive and hence less efficient.
And the twist on this paradox: “. . . in order for passive management to be a viable investment strategy, it critically depends upon a large number of individuals who do not believe that current market prices are efficient. As more and more money is invested in index vehicles, the markets tend to become less efficient. Yet inefficiency should make active investment more attractive and hence lead to a fall in the percentage of market capitalization invested in passive vehicles.” (p. 246)
Extracting two paragraphs from a 466-page book is, of course, a sorry excuse for a review, but take them as illustrative. This book is a treasure trove of insights for anyone interested in performance metrics, especially benchmarked performance metrics.