Swedroe: A Must-Read For Serious Investors

As the director of research for The BAM Alliance, and the author and co-author of 15 investment books, I’m often asked about other books I would recommend. For serious investors who want to gain a deeper understanding of how markets work and the strategies most likely to allow them to achieve their financial goals, my short list of “must-read” books (in alphabetical order by author) has been:

• “Expected Returns” by Antti Ilmanen
• “Successful Investing Is a Process” by Jacques Lussier
• “The Success Equation” by Michael Mauboussin
• “The Physics of Wall Street” by James Weatherall

I’m now adding Lasse Pedersen’s “Efficiently Inefficient” to that group. The book clearly is written for professionals and experienced investors who have taken a serious interest in what might be called “the science of investing,” or evidenced-based investing.

Imperfectly Efficient

Regarding the book’s title, Pedersen explains: “Markets cannot be perfectly efficient and always reflect all information. If they were perfect, no one would have any incentive to collect information and trade on it, and then how could markets become efficient in the first place? Markets also cannot be so inefficient that making money is very easy because, in that case, hedge funds and other active investors would have an incentive to trade more and more.”

His conclusion is that “the information contained in market prices must be efficiently inefficient, reflecting enough information to make it difficult to make money, but not so efficient that on one wants to collect information and trade on it.”

Later in the book, Pedersen writes: “The efficiently inefficient equity market has the property that prices can wander further from their fundamental values for illiquid stocks that are expensive to trade, volatile stocks that are risky to trade, stocks with large supply/demand imbalances, and stocks that are costly to short-sell, especially when active investors are facing reductions in capital and financing opportunities.”

Of course, this type of scenario presents an opportunity for certain investors (like Warren Buffett) who have the capacity and stock to accept such risks in bad times. That is why Buffett, who warns against trying to time markets, recommends resisting the temptation to be a seller when others are panicking and to be a buyer when others are greedy.

What Works, What Doesn’t

Pedersen compares and assesses the intelligent and systematic investment approaches likely to produce the best long-run performance. He does so by describing and analyzing the key trading strategies (including many “hedge fund” strategies, such as convertible arbitrage) used by some of the market’s most successful money managers.

In addition, he presents the evidence and logic—including both risk-based and behavioral-based explanations—for the success of each strategy he explores, and walks the reader through real-world examples.

While the first part of Pedersen’s book focuses on active investment strategies, such as those deployed by hedge funds, it contains advice valuable to every investor.

For example, the chapter on portfolio construction includes a list of key general principles employed by the most successful investors. Besides advising some of the largest companies in the world on managing financial risks, Pedersen has run trading rooms for two large financial institutions and advised individual as well as institutional investors for the past 20 years.

Given his wide experience, I believe his list should be framed and kept as a permanent reminder for all investors.

• The first principle of portfolio construction is diversification.
• The second principle is to implement position limits. In other words, don’t put so many eggs in one basket that, if that basket breaks, the loss is greater than is acceptable.
• The third principle is to make larger bets on higher-conviction trades. For instance—and this example is my own—if you have stronger evidence and believe more strongly in the value premium than the momentum premium, you should have a higher allocation to the value factor than the momentum factor.
• The fourth principle is to think of the size of a position in terms of its risk. For example, a 60 percent equity allocation doesn’t mean that you have 60 percent of the risk of the portfolio in stocks—it’s actually much greater.
• The fifth principle is that correlations matter, and when correlations tend to rise or fall also matters. An example I use is that while the carry trade historically has been profitable, it has “crash risk” that tends to show up at the same time equity risks does. It’s critical to consider this in deciding if you want to include exposure to this factor, as well as in deciding how much exposure you want. Another example involves junk bonds, whose correlation with equities is relatively low but tends to rise at the wrong time.
• The final principle is to continue to resize positions according to risk and conviction. I’d note that for “passive” investors, disciplined rebalancing is an important part of being successful. And having a systematic approach helps minimize the risks of making behavioral errors (allowing our own biases to impact our decision-making).

The Rest Of The Story

The second part of Pedersen’s book discusses three primary equity strategies, which he has broken down as discretionary equity trading; dedicated short bias; and quantitative equity investing. Pedersen provides the theoretical principles behind each of these strategies, and he ends each chapter with an interview with a respected practitioner.

One chapter concludes with a very informative interview with Cliff Asness of AQR Capital Management, who provided the following important insight: “One of the frustrating things about this business is how sensitive many investors are to short-term performance—in both directions … Many investors have a tendency to pile into investment strategies or managers who have recently had good performance, and they flee at the first sign of trouble, or, even worse, stick around a bit and get out at the worst possible time when it feels like it’s been losing forever, but statistically it’s not even that shocking. The problem with this behavior is that, if you poorly time the entry and exit of these strategies, you are not able to take advantage of the fact that these strategies make money over the long run.”

He then adds: “I shouldn’t whine too much; it’s probably why some of the strategies exist in the first place and don’t get arbitraged away as easily as some might assume, but it’s hard to keep that perspective at times.”

The book’s third part goes into the asset allocation process, as well as a discussion of macro strategies and managed futures (trend-following) strategies.

The book’s fourth part addresses three arbitrage strategies: fixed-income arbitrage; convertible bond arbitrage; and event-driven arbitrage. This is a particularly strong chapter because it shows in detail how the strategies work and the risks involved.

While Pedersen’s book certainly could be used in an MBA program’s finance courses (he developed the book from lecture notes to his own students), it doesn’t read like a textbook. And while it can be a bit heavy at times on math and equations, investors without strong skills in math will be able follow the main points because the writing is clear and concise.

If you’re looking to advance your knowledge of investment strategy, this book should be on your shopping list.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.