The Less-Efficient Market Hypothesis: Cliff Asness Takes on Traditional Finance

In a provocative new paper published in September 2024 titled The Less-Efficient Market Hypothesis, Cliff Asness, co-founder of AQR Capital Management and a former student of Nobel laureate Eugene Fama, argues that financial markets have grown less efficient over the past 30 years. This shift challenges the long-standing Efficient Market Hypothesis (EMH), which Fama helped establish as a cornerstone of modern finance. Asness claims that increased market inefficiency, particularly in the medium term, is causing stocks to deviate more from their fundamental values, requiring a longer time to correct these discrepancies.

Growing Market Inefficiency: The New Reality?

In his paper, Asness questions the traditional view that markets are always quick to reflect all available information, as posited by the EMH. He highlights that while value investing strategies—buying underpriced stocks and waiting for the market to correct them—still work, the time horizon for such corrections has extended.

Asness contends that inefficiency is rising due to three key drivers:

1. Technological advancements, with a focus on social media.
2. The gamification of trading, where ease of access and simplified platforms encourage speculative behavior.
3. Wider accessibility to financial markets, allowing more investors to participate but often without deep market knowledge.

Social media, in particular, has accelerated the spread of market sentiment, contributing to volatility. Platforms like Twitter, Reddit, and others amplify speculative behavior, causing stock movements that are often detached from underlying fundamentals. Asness asserts that this phenomenon has contributed to more frequent and pronounced price swings, making it harder for markets to quickly correct mispricing.

AQR Capital Management’s Rollercoaster Ride

Asness’s firm, AQR Capital Management, provides a real-world example of the challenges posed by a less efficient market. AQR was once one of the largest hedge funds, peaking at $226 billion in assets under management (AUM) in 2018. However, a series of underperforming systematic strategies—rules-based approaches that rely heavily on market efficiency—resulted in significant losses, cutting its AUM by half.

Despite these setbacks, AQR has rebounded in recent years. In 2022, the firm’s flagship Absolute Return strategy delivered a stellar 44 percent return, followed by a 19 percent return in 2023. These results reflect the ability of active management to outperform during specific market conditions, particularly when inefficiencies are more pronounced.

This performance rebound highlights a central theme of Asness’s argument: while markets may be less efficient, the opportunities for active managers to exploit these inefficiencies are greater, provided they have the right strategies and patience.

Active vs. Passive Investing: The Debate Continues

The rise of market inefficiency has fueled the ongoing debate between active and passive investing. According to Morningstar’s semiannual Active/Passive Barometer report, which compares the performance of active funds to their passive counterparts, only 29 percent of active funds outperformed passive peers over the 10-year period ending June 2024. However, in the shorter 12-month window ending June 2024, 51 percent of active strategies beat their passive peers.

This data suggests that market conditions may have become more favorable for active management in the short term, lending credence to Asness’s thesis that inefficiencies are growing. However, it’s important to note that the long-term data still favors passive investing, which aligns with the EMH’s claim that most investors cannot consistently beat the market.

Morningstar’s findings emphasize that while active management can capitalize on inefficiencies in the short term, long-term success remains elusive for most managers.

Fama’s Response: Standing by the Efficient Market Hypothesis

Despite Asness’s critique, Eugene Fama remains largely unshaken in his belief that markets are broadly efficient. In a September 2024 interview with the Financial Times, Fama acknowledged that markets are not perfectly efficient but argued that they are generally efficient enough to make it exceedingly difficult for most investors to consistently outperform. He noted that while individual prices may be “wrong” from time to time, the collective intelligence of millions of market participants typically corrects mispricings over the long term.

Fama’s Efficient Market Hypothesis has been instrumental in the rise of passive investing, which is now a dominant force in the asset management industry. Passive strategies, which track market indexes like the S&P 500, are built on the assumption that beating the market is not only difficult but rarely worth the effort, given the costs involved in active management.

“While prices may not always be perfectly accurate, market forces correct them,” Fama explained. “The key to success in any market—whether efficient or not—is maintaining a long-term investment horizon and a diversified portfolio.”

A Divergence in Investment Philosophy

Asness’s paper highlights a growing divergence in investment philosophy. On one side, proponents of the EMH, like Fama, continue to stress that markets, though not flawless, remain largely efficient. They argue that a diversified, long-term approach is the best path to success. On the other side, Asness and other active managers see today’s market inefficiencies as a golden opportunity for those with the skill and patience to exploit them.

The real question now is: who will be proven right in the years to come? As the markets continue to evolve, particularly with the rise of algorithmic trading, social media-fueled volatility, and increasing retail participation, the answer may lie somewhere in between.

Asness’s Less-Efficient Market Hypothesis serves as a timely reminder that while markets may be rational over the long term, the path to efficiency is often longer—and more volatile—than many expect.