“I have noticed that everyone who ever told me that the markets are efficient is poor.” — Larry Hite

A reader recently sent in the following PDF white paper on the Efficient Markets Hypothesis:

An excerpt:

Much of the existing evidence indicates that the stock market is highly efficient, and consequently, investors have little to gain from active management strategies. Such attempts to beat the market are not only fruitless, but they can reduce returns due to the costs incurred (management, transaction, tax, etc). Investors should follow a passive investment strategy, which makes no attempt to beat the market. This does not mean that there is no role for portfolio management. Returns can be optimized through diversification and asset allocation, and by minimization of investment costs and taxes. In addition, the portfolio manager must choose a portfolio that is geared toward the time horizon and risk profile of the investor. The appropriate mixture of securities may vary according to the age, goals, tax bracket, employment, and risk aversion of the investor. The goal of all investors is to achieve the highest returns possible. Indeed, each year investment professionals publish numerous books touting ways to beat the market and earn millions of dollars in the process. Unfortunately for these so-called “investment gurus”, these investment strategies fail to perform as predicted. The intense competition between investors creates an efficient market in which prices adjust rapidly to new information. Consequently, on average, investors receive a return that compensates them for the time value of money and the risks that they bear — nothing more and nothing less. In other words, after taking risk and transaction costs into account, active security management is a losing proposition. Although no theory is perfect, the overwhelming majority of empirical evidence supports the efficient market hypothesis. The vast majority of students of the market agree that the markets are highly efficient. The opponents of the efficient markets hypothesis point to some recent evidence suggesting that there is under and over-reaction in security markets. However, it’s important to note that these studies are controversial and generally have not survived the test of time. Ultimately, the efficient markets hypothesis continues to be the best description of price movements in securities markets.

TurtleTrader comment: The Efficient Markets Hypothesis seems incomplete. To some degree if it is accepted, then the great Trend Followers (and their 30 years of performance) should not exist. The paper above states that investors should make no attempt to beat the market. This seems shortsighted. The PDF report seems to portray successful traders as only lucky. We do not think they are lucky. An interesting book that further investigates the Efficient Markets Hypothesis is When Genius Failed.

What the Efficient Markets Hypothesis Gets Wrong

Larry Hite’s observation is pointed because it is empirical rather than theoretical. He is not arguing against the EMH on academic grounds. He is noting that the people who argue most confidently for the theory tend not to have demonstrated the ability to generate returns in markets. The theory serves as a convenient explanation for why active management does not work for most practitioners, and for many it does not. But the existence of a 30-year audited performance record among systematic trend followers is a direct empirical challenge to the claim that markets are so efficient that sustained outperformance is impossible.

The paper’s argument contains its own weakness in the passage about under and over-reaction: “it’s important to note that these studies are controversial and generally have not survived the test of time.” The performance records of systematic trend following managers have survived the test of time. They span multiple decades, multiple market cycles, multiple regulatory environments, and multiple technological eras. If these records are the product of luck, the luck is extraordinarily persistent and extraordinarily correlated across independent managers operating in different markets with different specific systems. The correlation data showing that trend followers make money in the same months in the same markets is not the fingerprint of luck. It is the fingerprint of a common systematic response to real market behavior.

The EMH in its strong form essentially predicts that the traders profiled throughout this site should not exist. The weak form, which acknowledges that prices do not always fully and immediately reflect all information, leaves room for systematic approaches that read price momentum rather than fundamental information. Trend following is not a claim that markets are irrational. It is a claim that price trends, which are consistent with behavioral finance findings about under and over-reaction, can be captured systematically. The EMH debate ultimately comes down to which body of evidence you weigh more heavily: theoretical arguments about information processing or the actual performance records of traders who have operated across decades. We choose the latter. More on why trend following works where EMH-based passive strategies leave money on the table, and on the full documented history in the TurtleTrader story.

Frequently Asked Questions

What is the Efficient Markets Hypothesis?

The EMH holds that asset prices fully reflect all available information, making it impossible to consistently achieve returns greater than the market average through active management. In its strong form it argues that no trading strategy can produce sustained outperformance because any exploitable pattern would be immediately arbitraged away by competing investors.

Why does trend following challenge the Efficient Markets Hypothesis?

Because the multi-decade audited performance records of systematic trend following managers represent exactly the kind of sustained outperformance the EMH says should not exist. If markets were fully efficient, the correlated profits produced by independent trend following managers in the same months and the same markets would be impossible. The performance is not a theoretical argument. It is documented evidence.

If the EMH is correct, why do trend followers succeed?

The EMH in its weak form acknowledges that prices do not always immediately and fully reflect all information, leaving room for behavioral patterns like under and over-reaction. Trend following exploits exactly these patterns. It does not claim that markets are irrational. It claims that price movements exhibit momentum characteristics that can be captured systematically before full efficiency is restored.

What does Larry Hite’s quote mean?

It means that the strongest advocates of market efficiency tend to be theorists rather than practitioners, and that practitioners who have actually traded markets successfully over long periods generally do not believe in the strong form of the EMH. The theory explains why average active management underperforms. It does not explain why systematic trend following has outperformed across decades of documented returns.

Trend Following Systems
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