Should-Read: Noah Smith: Rational Markets Theory Keeps Running Into Irrational Humans

Should-Read: Noah Smith: Rational Markets Theory Keeps Running Into Irrational Humans: “To many young people, the idea of efficient financial markets—the idea that…

…in the words of economist Eugene Fama, “At any point in time, the actual price of a security will be a good estimate of its intrinsic value”—probably seems like a joke. The financial crisis of 2008, the bursting of the housing bubble, and gyrations in markets from gold to Bitcoin to Chinese stocks have put paid, at least for now, to the idea that prices are guided by the steady hand of rationality. The theory won Fama an economics Nobel Prize in 2013, but he shared it with Robert Shiller, whose research poked significant holes in the idea decades ago. But believe it or not, there was a time when efficient markets theory occupied a place of honor in the worldview of economists and financial professionals alike….

In “ETF Arbitrage and Return Predictability,” economists David Brown, Shaun Davies and Matthew Ringgenberg take advantage of the way exchange-traded funds are structured. An ETF typically has a designated set of traders called “authorized participants” (APs) who are able to carry out arbitrage between the fund and its underlying assets, whether stocks, bonds or commodities. When the price changes, APs respond by buying and selling the underlying assets, and by either creating or redeeming shares of the ETF, until the two values come back into line. They are, by design, rational arbitrageurs. Generally, an ETF’s APs do a good job of keeping the fund’s value close to the value of the assets it owns. Many studies confirm this. But Brown et al. find that APs’ arbitrage coincides with a deviation of asset values from their fundamentals. When traders other than the APs push around the price, the changes in the prices of the assets tend to reverse themselves over the subsequent months. Anyone watching the APs’ arbitrage trades—which are public record, since they involve the creation and destruction of ETF shares—can then bet that the recent rise or fall in the price of the assets underlying the ETF will be reversed. And make a lot of money. Under efficient markets theory, that’s not supposed to happen….

Efficient markets theory never really fits the facts, but it never quite dies, either.