As the efficient markets hypothesis turns 50, it is time to bin it

Investment strategies determined by price alone are creating systematic and chronic distortions

Paul Woolley

Italian government bonds on trading screen taken from osb bloomberg trading screen
The efficient markets hypothesis continues to underpin some of the most important decisions taken by investors, from the largest institutional funds to the smallest private saver © FINANCIAL TIMES

People keep questioning the health of global capitalism.

But the damage caused by dysfunctional stock markets is not receiving adequate attention.

Fifty years on from the publication of a landmark paper propounding the efficient markets hypothesis — that investors respond rationally to publicly available information — it is time to look again.

Active investing comprises two main strategies. One is based on expectations of the cash flows each asset can generate. The other responds to short-term price movements and ignores fundamental value.

Cash flow investing and price-only investing are implemented in a variety of ways, and together they represent the sum of investors’ actions in determining the prices of assets.

The efficient markets hypothesis takes account only of the first strategy, implying that prices reflect the consensus expectations of cash flow investors. Although modified and qualified over the years, the basic proposition remains unchanged.

But consider the evidence of trends and momentum, and bubbles and crashes. Market participants observe the impact of short-term fund flows and are ambivalent — at best — about the idea of markets being efficient. They know that a high proportion of stock market trades bear no relation to fundamental value and that few professional portfolios are actually invested exclusively for long-term cash flows.

Despite these reservations and for lack of an alternative, the efficient markets hypothesis continues to underpin some of the most important decisions taken by investors, from the largest institutional funds to the smallest private saver.

One prime example of the problem is the use of capitalisation-weighted indices as benchmarks for the composition of passive funds, and for the performance of active funds. The comparison of portfolio returns against index returns is deemed good practice, however short the period under review. But treating indices as the neutral default choice makes sense only if pricing is efficient.

For their part, policymakers assume that stock markets reflect the wisdom of crowds and have a hands-off attitude, confining themselves to picking up the pieces after each crash. They use mark-to-market rules in the regulation of financial institutions and approve products that improve liquidity or widen the range of choice. That is sensible in an efficient world, but not otherwise.

A better understanding is needed of why investors use these strategies and how this usage distorts prices. Research at the London School of Economics has focused on agency problems arising when asset owners and fund trustees delegate responsibility to external managers. The main concern here is that trustees are uncertain of the ability of their asset managers.

Accordingly, most trustees impose limits on how far returns should stray from the return of the benchmark index. Even when unconstrained, managers are keen not to let performance slip far below the index return lest their competence is questioned.

Benchmarking pressures come to the fore when prices in a sector, or a class of assets, move strongly ahead. Managers who had previously deemed a sector to be unattractive and had not participated in the rise are obliged to turn buyers at the higher price. That amplifies the initial rise to the point where the assets become high-risk and overpriced.

Below-index weights in stocks or sectors with rising prices have a greater, and potentially unlimited, impact on performance compared with overweight positions in those with falling prices. So the pressure to act is always stronger when markets are rising.

One price-only strategy spawns another, worsening the situation. Benchmarkers must act when prices pass a threshold — but momentum investors buy as soon as a trend becomes apparent.

The latter are effectively exploiting benchmarkers who have no alternative but to pay the higher prices.

The outcome is a generalised bias to overvaluation. This analysis is consistent with the longstanding evidence that high-risk stocks have historically given a lower return than their low-risk counterparts.

The price-only strategies overlooked by the efficient market hypothesis are creating systematic and chronic distortions that are too great to be countered by cash flow investors.

It is no surprise that a theory predicting efficiency cannot explain inefficiency, nor show investors how to act correctly in conditions of inefficiency. On the other hand, a theory of dysfunctional markets points to the source of trouble and can suggest solutions.

These include amending the terms of delegation from trustee to asset manager, so that the latter focuses solely on long-term cash flows, coupled with improved monitoring by trustees to ensure compliance. More efficient markets would deliver private gains for all except the mischief-making momentum players.

But the biggest prize would be the social benefits from a more efficient allocation of capital.

That could provide a new lease of life for capitalism.

The writer is a senior fellow at the London School of Economics

Why Down Under Is Burning Up

Bush fires have many causes. The climate-change narrative is a gross oversimplification.

By James Morrow

Fire Crews monitor bush fires in Mallacoota, Australia, Jan. 2. Photo: Darrian Traynor/Getty Images 

I’ll never forget my first Christmas in Australia. The year was 2001. The mercury hovered around 100 degrees Fahrenheit—you don’t get a white Christmas in Sydney. From the balcony of an apartment overlooking Bondi Beach, I watched the sky turn from a bright blue to an ashen gray to a brackish brown as smoke poured down from over the hill behind us. What would later be known as the Black Christmas fires raged in the Blue Mountains, 50 or so miles inland.

Climate change hadn’t become the catchall explanation for natural disasters. My hosts, who grew up with bad fire seasons, shook their heads and served the turkey.

Nearly 20 years later, much of the eastern half of the country has again been hit with bad bush fires.

The current round of blazes started late last year. It has charred at least 15 million acres and killed more than two dozen Australians, including brave volunteer firefighters who rush into the inferno to save homes and lives.

The climate-change narrative grossly oversimplifies bush fires, whose causes are as complex as their recurrence is predictable:

Australia is in the midst of one of its regular droughts.

Byzantine environmental restrictions prevent landholders from clearing scrub, brush and trees. State governments don’t do their part to reduce the fuel load in parks. Last November a former fire chief in Victoria slammed that state’s “minimalist approach” to hazard-reduction burning in the off-season. That complaint is heard across the country.

As for the proximate cause, anything from a lightning strike to a spark from a power tool to arson can touch off a conflagration. More than 180 people have been arrested for allegedly starting blazes since the start of the current bush-fire season.

Yet the narrative that has been built around the fires and broadcast around the world points the finger only at man-made climate change—and specifically at Prime MinisterScott Morrison.Activists insist that if his government had an effective “climate policy,” it would somehow help snuff out the flames.

Never mind that Australia emits only around 1/77th of the world’s man-made carbon dioxide. The country’s complete deindustrialization wouldn’t budge the global thermostat.

In radical corners of Australian social media, activists play out fantasies of the government’s dissolution and replacement with some sort of revolutionary people’s climate assembly taking power (surely, they’ll get it right this time). On Monday a parliamentarian from the Australian Greens tweeted about one day holding “climate trials” to deal with conservative politicians.

The climate blame game is driven in large part by an Australian left still smarting from its election loss last May, when the smart money had it that Mr. Morrison would be shown the door in favor of a progressive government led by the Labor Party.

Like Brexit, Donald Trump and Boris Johnson, Mr. Morrison was not supposed to win according to the chattering classes—the “luvvie left” as they’re known in Australia. A socially conservative churchgoing Christian and father of two who presents as a slightly goofy suburban everyman—a “daggy dad,” as they say—Mr. Morrison won over the country. His Liberal Party, in coalition with the National Party, took seats across suburban and rural Australia, leaving only the most fashionable urban districts to Labor and the Greens.

Mr. Morrison’s enemies thought they’d found an opening with the fires. They leapt on a poorly timed family holiday, which saw Mr. Morrison absent when things started to get bad, and an initial response when he returned that many found underwhelming.

Yet it’s unlikely the country will be forced into some radical climate program.

Australians understand that their climate has always been one of the deadliest in the world, and that the country’s modern history is signposted with huge and deadly bush-fire seasons.

Being a pragmatic, realistic lot, they know that no act of economic self-harm can do anything to change the weather.

Mr. Morrow is opinion editor of Australia’s Daily Telegraph.

Europe’s New Green Identity

The European Union has already invested so much of its political capital into the green transition that a failure to fulfill its promise to achieve climate neutrality by 2050 would severely damage its legitimacy. The Green Deal is not just one of many EU projects. It is the Union’s new defining misión.

Jean Pisani-Ferry

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PARIS – Most countries’ flags are multicolor. Together with red-flagged China, the blue-flagged European Union is one of the few monochrome entities. Not anymore, apparently: the EU’s new defining project colors it green. At a meeting in mid-December, the leaders of all EU countries except one (Poland, not the United Kingdom) officially endorsed the goal of achieving climate neutrality – zero net emissions of greenhouse gases – by 2050.

European Commission President Ursula von der Leyen wants to go further. Next March, she plans to introduce a “climate law” to ensure that all European policies are geared toward the climate neutrality objective. She wants member states to agree next summer to cut emissions by about 50-55% between 2017 and 2030.

She also proposes to allocate half of the European Investment Bank’s funding and a quarter of the EU budget to climate-related objectives, and to devote €100 billion ($111 billion) to supporting regions and sectors most affected by decarbonization. If non-EU countries drag their feet, she intends to propose a carbon tariff.

Grand plans for a distant future rightly elicit skepticism. For leaders facing reelection every four or five years, a 2050 objective is hardly binding. A battle is to be expected: opposition by fossil fuel-producing member states, energy-intensive sectors, trade-sensitive industries, and car-dependent households will be fierce.

The EU has already invested so much of its political capital into the green transition, however, that a failure to deliver would severely damage its legitimacy. The Green Deal is not just one of many EU projects. It is the Union’s new defining mission.

Let us therefore assume that the EU commits to von der Leyen’s plan. Will it work?

Relative to what other big emitters have agreed to do, the proposed EU target is commendably ambitious. Yet it falls short of what is needed to safeguard the world’s climate. To prevent the rise in temperature from crossing the safe threshold of 1.5º Celsius, future global cumulative emissions must be limited to about seven times the current level. At prevailing emission levels (which are still rising), humanity’s total carbon budget will be exhausted in seven years.

The additional carbon budget the EU is setting itself with its super-ambitious plan amounts to roughly 15 years of current-level emissions (somewhat less if efforts are front-loaded). Given that developing countries should be allocated a proportionally larger budget than advanced economies, global emissions would remain far too high even if all countries suddenly emulated the EU. The sad truth is that the 1.5º target is already out of reach, and the EU’s laudable plan is a bare mínimum.

Is the plan realistic? That is hard to say at this early stage, but it is already clear that the full range of required policy tools cannot be mobilized at the EU level alone. The Union decides on allowances for energy-intensive industries and car-emission standards, but it cannot rule directly on the member states’ energy mix, housing standards, taxes, and public investment.

Much will depend on national ownership of the common targets, which currently is unequal, to say the least: CO2 emissions are taxed at €113 per ton in Sweden and €45 in France, but they are tax-exempt in Germany and Italy. Designing and enforcing a common EU strategy will be a difficult fight.

Frustrated climate advocates often put their faith in financial instruments. Having lost the battle for tough regulation and dissuasive taxation, their hope is that green finance will do the job. It is true that an increasing number of investors shy away from “brown” assets, either by choice or because of regulators’ warning that oil fields and coal plants may lose much of their value and end up as “stranded” assets.

And it is true that favorable regulatory treatment of climate-friendly investment, de-risking through financial engineering, and credit subsidies can spur green capital formation. Even central bankers are actively debating what to do to for the climate.

But such techniques are rather inefficient. Financial dissuasion may help curb dirty investments, and a panoply of incentives may help promote clean ones, but at a high economic cost.

As long as the climate policy is not fully credible, each ton of greenhouse gas saved will entail more output losses than if tomorrow’s carbon price were predictable. And as purchase subsidies for cleaner vehicles have shown, support for green technologies, if not coupled with carbon taxation, may well end up prompting higher energy consumption.

To be sure, decarbonization cannot rely on first-best policies alone. But experience has shown that it is fairly easy to burn through lots of money with little to show for it. And public support for mitigating climate change is not such that price is not an issue.

At the end of the day, success will largely depend on whether the greening of the economy helps create jobs and prosperity. The European Commission claims that the Green Deal is Europe’s “new growth strategy.” This will enrage supporters of “de-growth.”

But the Commission is right to emphasize that decarbonization and growth must go hand in hand. The transition to carbon neutrality will destroy wealth, cause job losses in energy-intensive sectors, and require lifestyle changes. It will elicit sufficient support to overcome opposition only if it generates economic dynamism.

The Commission claims that its plan will spur €260 billion of additional investment annually. The details can be discussed, but as a rough estimate of what is needed, the figure seems reasonable. Yet this investment will materialize only on the basis of a sustained, all-encompassing, and credible implementation of what is still a blueprint.

When the Spanish explorer Hernán Cortés landed in Veracruz, Mexico, 500 years ago, he ordered his troops to burn their ships. Only then could the meager unit truly understand that victory was the only option. By announcing its new Green Deal, the EU has done much the same thing.

Jean Pisani-Ferry, a senior fellow at Bruegel, a Brussels-based think tank, holds the Tommaso Padoa-Schioppa chair at the European University Institute, and is a visiting fellow at the Peterson Institute in Washington, DC.

Work Clothes, Reimagined for an Age of Wearable Tech

Work wear is due for a technological upgrade, from touch-screen sleeves to collars that change color based on mood

Ben Martin for The Wall Street Journal

In the future of work fashion, data is the new black.

The clothes we wear to work will be sensor-embedded and connected, monitoring stress levels, reminding us of appointments, alerting us and others when there’s important work to be done and more, says Rebeccah Pailes-Friedman, author of the 2016 book “Smart Textiles for Designers: Inventing the Future of Fabrics,” and head of a consulting firm specializing in wearable technology and smart textiles.

Much of this technology already exists in apparel used in the military, medicine and sports.

Blue-collar and white-collar workplaces are the next frontier.


Levi Strauss & Co. uses Google's Jacquard software platform in a denim trucker jacket. It allows the wearer to tap, swipe or hold an area of the garment to read and respond to messages and receive notifications. Photo: Levi's 

Say goodbye to smartphone reminders.

Instead, the sleeve of your shirt, suit jacket or dress will glow, blink or vibrate with alerts.

Launched in 2017, Google’s Jacquard platform allows manufacturers to place a small, Bluetooth-enabled tag, which connects to an app, in clothing, backpacks, shoes and more.

A combination of specially developed threads, embedded electronics and software allows the wearer to tap, swipe or hold an area of the garment to read and respond to messages and receive notifications.

Levi Strauss& Co.’s Levi’s brand already uses the technology in a $198 denim trucker jacket, after first trying it in a jacket aimed at urban cyclists.

For that design, the company studied bike messengers to improve the experience of cycling to, from and for work, according toPaul Dillinger,Levi’s head of global product innovation.

Ivan Poupyrev, Google’s director of engineering and the inventor of Jacquard, envisions future applications for business attire. “You can check stock prices,” he says, or blinking LEDs could notify the wearer when it’s time to get to a meeting and provide directions to the conference room.

The technology will be subtle in appearance: “We found that brands were reluctant to put too much visible technology on the product,” Mr. Poupyrev says. “It’s really important that the product doesn’t feel like a gadget.”


San Francisco-based Sensoree’s ‘mood sweater’ has a LED-studded collar that lights up in different colors based on galvanic skin response. Photo: Sensoree 

Next time your boss is getting under your skin, your skin may just tell her how you feel.

Interactive clothes that light up or change color—supposedly depending on the wearer’s mood—may be coming to the office.

Sensoree, a San Francisco-based maker of therapeutic wearables, has developed a “mood sweater.”

The garment has a LED-studded collar that lights up in different colors based on galvanic skin response, or a change in the electrical characteristics of the skin prompted by stress, excitement, pleasure or other feelings.

Founder Kristin Neidlinger,a biomedia designer, says the clothes could help with nonverbal communication at work.

“We found it really good in team-building exercises. People really connect a lot faster.”

The company recently did a study of 12 small groups and found that people’s cardiovascular, respiratory and body temperature signals synchronized more when they were made visible by the sweaters. “They got the tasks done a lot faster with better results,”

Ms. Neidlinger says. Sensoree is seeking partners for a launch of the design.

The “mindfulness craze” might help the product gain wider acceptance, Ms. Neidlinger says, but not everyone is sold. “They’re like, ‘You’ve designed my worst nightmare. I’m trying to hide my emotions.’

But wouldn’t it be easier if you just show them?”

Bolt Threads' Mylo is a synthetic leather whose main ingredient is mycelium, a fungus found in the root structure of mushrooms. Photo: Bolt Threads 

Startups including House of Fluff, Modern Meadow and Bolt Threads are developing faux fur, leather and silk using everything from recycled plastics and polyester threads to mushrooms, microbes, collagen proteins and synthetic spider silk.

These lab-grown or vegan materials are touted as more environmentally friendly and humane. Wool and cotton alternatives are on the horizon, which could radically change the men’s and women’s business suit and dress-shirt industries.

Cotton requires vast amounts of water to produce and is treated with pesticides; the production of wool requires the shearing of sheep, which also creates methane that contributes to greenhouse-gas emissions.

Keanan Duffty,founding director of Parsons School of Design’s MPS Fashion Management program, says that biofabrics can sound “a bit ‘Star Trek,’ ” but their appearance in high-end work clothing isn’t far-fetched. A Salvatore Ferragamo collection in 2017 used fibers from orange peels as a silk alternative, he adds.

“I don’t believe that we’re going to use cotton in the next 20 years,” says Renana Krebs, the Tel Aviv-based co-founder and chief executive of Algalife, a startup that develops biodegradable materials from algae. She predicts an increase in renewable materials that are good for both the environment and skin showing up in workwear.


Harvard Biodesign Lab is developing an ‘exosuit,’ a lightweight, motorized, backpack-like device, to help alleviate workers’ back strain. Photo: Harvard Biodesign Lab 

For workers who perform strenuous, repetitive tasks, wearable robotic technology could help take the load off.

The Harvard Biodesign Lab is developing an “exosuit,” a lightweight, motorized, backpack-like device, to help alleviate back strain by 20% to 30%, says Conor Walsh, a Harvard engineering professor and founder of the lab.

A motor, sensors and a microprocessor system inside monitors the wearer’s movements.

When the device detects lifting motions, it sends a command to the motor to generate tension on straps across the back and hips, thereby assisting the wearer in picking up the object.

It could help logistics workers who are repeatedly hefting packages by reducing fatigue and mitigating the risk of injury.

This month, the lab plans to spin off a startup called Verve to commercialize the device.

Ms. Pailes-Friedman, the author and consultant, is developing mechanized clothing for people with physical jobs, such as nurses, along with Nashville-based HeroWear.

“One of the things we’re trying to do is make the exosuit less robotic and more in your clothing,” says Ms. Pailes-Friedman, an adjunct professor at Pratt Institute.

Rich Mahoney,chief executive of Seismic, a Menlo Park, Calif.-based designer of robotic wearables, expects to integrate its powered elements into uniforms and other clothing.

This kind of wearable support could also be used by white-collar workers who have difficulty being seated for long periods, saysYves Behar,founder of fuseproject, a San Francisco industrial design and branding firm.


The technology in Wearable X's yoga leggings—sensors and an app that help the wearer with proper alignment and posture—could one day help office workers. Photo: Wearable X 

Next up: clothes that signal when your desk mate should leave you alone—thanks to sensors that measure heart rate as a proxy for productivity and stress levels.

Anouk Wipprecht,a Dutch designer who creates “robot couture,” developed two sensor-laden dresses—one that has movable mechanical arms and another that emits smoke—that react when someone encroaches on the wearer’s personal space.

The designs are conceptual, but Ms. Wipprecht imagines potential workplace applications in high-stress fields. “If there’s a little indicator that the person might be in a really high-focused area at that point, then this is actually helping the person get their stuff done,” she says.

New York fashion-tech company Wearable X’s yoga leggings use sensors sewn into the nylon and a corresponding app to help the wearer with proper alignment and posture.

It’s possible the same setup could one day help office workers, saysBillie Whitehouse,co-founder and chief executive, by prompting the wearer to uncross her legs or perform back stretches throughout the day.


MIT's Self Assembly Lab and apparel company Ministry of Supply have developed a sweater made of a textile that adapts to the wearer’s body temperature. Photo: Ministry of Supply

Temperature-regulating technology could one day eliminate the need for that extra office sweater or scarf. Boston-based clothing company Ministry of Supply came out in 2018 with a jacket that uses Bluetooth to control a built-in thermostat and heating elements.

Founded by four MIT alumni, the company is now working with the school’s Self-Assembly Lab to develop a business-casual sweater that continually adapts to the wearer’s body temperature.

The material is made up of polymers that react when exposed to heat; its structure contains pores that close up to trap heat when the wearer is cold and open up to let in more air flow when a person is hot.

The vision?

“Something that works even if the batteries are dead,” says Gihan Amarasiriwardena, co-founder and president. Men’s and women’s versions are slated to go on sale in the second quarter of this year.