1. Lasse Heje Pedersen Copenhagen Business School, NYU, CEPR,
AQR Capital Management

2. Overview of talk Efficiently inefficient How smart money invests &
what does it mean?
How smart money invests &
Demystifying the secret world of hedge funds
How do you beat the efficiently inefficient market?
market prices are determined
Efficiently inefficient economics

3. Market efficiency Inefficient! Efficient!
Market efficiency: at the heart of financial economics
Nobel Prize 2013 awarded to Eugene Fama, Lars Hansen, and Robert Shiller
Inefficient!
Efficient!

4. Efficient Markets? Markets cannot be fully efficient
If they were, no one would have an incentive to collect information (Grossman-Stiglitz, 1980)
Logically impossible that both market for asset management and asset markets fully efficient
Asset market efficient  no one should pay for active management
Clear evidence against market efficiency
Failure of the Law of One Price, e.g.
Siamese twin stock spreads
Covered Interest-rate Parity
CDS-bond basis
not subject to joint hypothesis problem
Completely
Inefficient
Perfectly
Efficient
Efficiency-o-meter

5. Inefficient Markets? Markets cannot be completely inefficient
Money managers compete to buy low and sell high
Free entry of managers and capital
If markets were completely inefficient
Making money should be very easy
But, professional managers hardly beat the market on average
Completely
Inefficient
Perfectly
Efficient
Efficiency-o-meter 5

6. Efficiently Inefficient Markets
Markets are efficiently inefficient
Markets must be
inefficient enough that active investors are compensated for their costs
efficient enough to discourage additional active investing
Investment implications
Some people must be able to beat the market
at least before transaction costs and fees
but even after costs, though, of course, less so
Market Efficiency
Investment Implications
Efficient market hypothesis
Passive investing
Inefficient market
Active investing
Efficiently inefficient markets
Active investing by those with comparative advantage
Efficiently
Inefficient
Completely
Inefficient
Perfectly
Efficient
Efficiency-o-meter 6

7. Is the world Efficiently Inefficient ?
Competition + frictions = efficiently inefficient dynamics Efficiently inefficient traffic dynamics Efficiently inefficient political process Efficiently inefficient nature: evolution has not converged yet

8. Beating the Market when its efficiently inefficient
Beating the market is very hard, but possible
You need to master certain fundamental techniques
You must incur significant costs/risks
Asset management arises naturally due to returns to scale

9. How Smart Money Invests in efficiently inefficient MarketS

10. How Do You Beat the Market? Liquidity provision
How do you make money in any business?
E.g., consider a burger bar:
Customers are willing to pay more for a burger than the value of meat+bun+salad
Burger bars make profits for proving a service, but free entry ensures that profits are efficiently inefficient
How do you make money investing?
Institutional frictions make certain investors “demand liquidity”
Active money managers provide liquidity by taking the other side
Free entry drives the price of liquidity to its efficiently inefficient level
Reflects risk, operational costs, transaction costs, funding costs
Liquidity

11. How Do You Beat the Market? Liquidity provision
buying
illiquid
convertible
bonds
stat.arb.
provides
liquidity
vis-à-vis
supply/demand
imbalances
providing
fixed income
liquidity
due to
institutional
frictions
providing
liquidity
to sellers
of merger target

12. How Do You Beat the Market? Investment styles
1000s of hedge funds and active mutual funds
across different markets, continents, asset classes, …
But, can we summarize the main trading strategies through a few investment styles?
method that can be applied across markets
based on economics
broad long-term evidence
Investment styles
Liquidity provision
Value investing
Trend-following
Carry trading
Low-risk investing
Quality investing
Buffett’s performance

13. Investment styles: Value and Momentum everywhere
Asness: we’re looking for cheap stocks that are getting better, the academic ideas of value and momentum Ainsley: sustainable free cash flows in comparison to enterprise value… it’s certainly important to be attuned to short-term expectations as well Chanos: we to try short overvalued firms… if a position is going against us, we’ll trim it back Soros: I look for boom-bust cycles Harding: trends are what you’re looking for Scholes: most of the fixed income business is a negative-feedback-type business unless you're directional, which is positive feedback, or trend following Griffin: view markets through the lens of relative value trading Paulson: the target stock runs up close to the offer price but trades at a discount to the offer price because of the risks of deal completion
Source: Value and Momentum Everywhere, Asness, Moskowitz, and Pedersen (2013, Journal of Finance)

14. How Market Prices Are Determined
Neoclassical models of full efficiency:
Irrational traders either cancel each other out or have no effect on prices due to arbitrageurs
Behavioral finance
Irrational traders make common mistakes and arbitrage is limited
Prices bounce around the neoclassical value
Efficiently inefficient markets
Liquidity risk and other institutional frictions directly affect the price
Efficiently Inefficient Equity Markets
Efficiently Inefficient Macro
Efficiently Inefficient Arbitrage Spreads

15. Conclusion: efficiently inefficient EconomicS
Neoclassical Finance and Economics
Efficiently Inefficient Markets
Modigliani-Miller
Capital structure matters
Two Fund Separation
Investors choose different portfolios
Capital Asset Pricing Model
Liquidity risk and funding constraints
Law of One Price and Black-Scholes
Arbitrage opportunities
Merton’s Rule
Optimal early exercise and conversion
Real Business Cycles, Ricardian Equivalence
Credit cycles and liquidity spirals
Taylor Rule
Two monetary tools