Taking aim at efficient market theory

Winton founder David Harding slams ‘weak’ theoretical basis for alternative beta

The founder and CEO of Winton – David Harding – is fighting back against the explosion of products aiming to replicate the trend-following strategies of managed futures firms like his, but for much less cost.

In a September update for Winton's investors, Harding slams strategies carrying "fancy but incomprehensible" titles such as alternative beta, crisis risk offset, or tail risk protection, saying they are the product of academic theory that should have been discredited by previous market slumps.

Harding sketches the history of the managed futures industry from its beginnings in the 1980s, saying the industry prospered using systematic strategies while followers of the Chicago school's efficient market theory ignored how markets reflect more than just fundamentals.

To Harding, the 2008 crisis – when managed futures performed well, earning them a reputation as a potential source of so-called crisis alpha – should have put a stop to the efficient markets view. But the view has endured with worrying implications, he says.

"The efficient market theory proponents, having looked into the abyss, lived to fight another day. Instead of the theory being totally discredited, it has survived, with amendments, but still recognisably intact."

Recent years have seen an explosion in products based on harvesting identifiable risk premia – seen as sustainable sources of return based on structural or behavioural features of markets. About 300 such premia have been pinpointed in academic work, although most activity centres on half a dozen, of which momentum is one.

Harding says: "After 30 years of denying the possibility of momentum as a phenomenon existing in markets, the orthodoxy has now incorporated it into efficient market theory with the status of eternal truth."

But the theoretical underpinning of such strategies is weak, he argues: "Correlation between stocks, bonds and managed futures funds is not a meaningful statistic. Managed futures funds are not an asset class but an industry. Momentum isn't an immutable property of markets, but one that has been observable in the recent era."

If Harding is right, there are two reasons to be concerned.

First, many institutional investors may be relying on such strategies as part of their tail-risk hedging strategies. Risk.net hears of pensions consultants presenting managed futures strategies in this way – as a direct mitigant to the next crisis as they foresee it. Certainly some managed futures funds are uncomfortable being painted as a fail-safe source of crisis alpha.

And second, as Harding says himself, adherence to the view of markets as efficient – if mistaken – could lead to or worsen a future crisis.

"When an institution allocates to a momentum strategy in the hope of cushioning itself from stock-market downdraughts, it is really commissioning someone to sell stocks on its behalf into a falling market; no different to the failed portfolio insurance strategy that was implicated in the 1987 crash."

For this reason, Winton treats endogenous shocks as a key threat. Examples of such shocks emerging from within markets include the troubles with portfolio insurance in 1987, Long Term Capital Management's collapse in 1998 or the so-called quant crisis in 2007. Harding is also keen to assert his firm has moved away from simplistic momentum-based strategies.

"If the odd institution wishes to protect itself [using momentum strategies] there is no contradiction, but if they all do, the risk of destabilising short-term market behaviour will once again be high," he concludes.

Asset owners might disregard these differences of opinion in the industry as academic. But weighing the arguments now is worthwhile, rather than finding out who is right in future and turning out to be ill-prepared.