Efficiently Inefficient: How Smart Money Invests & Market Prices Are Determined. 2015Lasse Heje Pedersen.

Efficiently Inefficient: How Smart Money Invests & Market Prices Are Determined is a comprehensive guide to strategies used by hedge funds. It covers both equity and fixed income and explains such diverse approaches as quantitative, macro, dedicated short bias, and many more. The author is Lasse Heje Pedersen, who is a professor at Copenhagen Business School and the New York University Stern School of Business and a principal at AQR Management. As an illustration of the thoroughness exhibited by the author, the section on statistical arbitrage details techniques involving dual-listed shares, multiple share classes, pairs trading, reversal strategies, index arbitrage, and closed-end fund arbitrage.

Each chapter is dedicated to a particular strategy and includes an interview with one of its foremost practitioners. Pedersen has enlisted in his enterprise such luminaries as Lee Ainslie III, Cliff Asness, Ken Griffin, David Harding, Myron Scholes, and George Soros. Particularly valuable is John Paulson’s discussion of the nuts and bolts of risk arbitrage and bankruptcy investing.

The author sets the stage for his taxonomy of trading strategies with an overview of active management, in which he addresses such topics as backtesting, performance measurement, risk management, and funding. Clearly, none of these activities would justify the time and energy expended on them unless active management held out the promise of superior risk-adjusted returns. Accordingly, the book’s initial section takes up the timeless question of market efficiency.

Pedersen comes down between two extreme views on the subject. He maintains neither that security prices instantaneously impound all new information nor that markets routinely deviate from fundamentals because of investor errors and biases that do not cancel out in aggregate. The midway position, whence the book’s title derives, is that the market is “just inefficient enough that money managers can be compensated for their costs and risks through superior performance and just efficient enough that the rewards to money management after all costs do not encourage entry of new managers or additional capital” (emphasis in original). As the author effectively acknowledges in a footnote, his formulation elaborates on a paradox noted by Sanford Grossman and Joseph Stiglitz: Investors need an incentive to collect information, which does not exist if markets are perfectly efficient. Grossman and Stiglitz conclude that an “equilibrium level of disequilibrium” must exist in the market.

As for the effectiveness of the numerous strategies he details, Pedersen provides a somewhat tepid endorsement. He states that a trading strategy works if it “historically produce[s] positive average returns and may have a chance of outperforming on average in the future, but not always, not without risk, and the world can change.” After taking into account various biases in the reporting of hedge funds’ investment results, he merely asserts that there is evidence of trading skill among the best hedge funds, “especially when considering performance before fees” — that is, when measured at a level that is irrelevant to investors. The author adds that some research finds persistence of superior performance but the persistence is not strong. His commendable candor is hardly calculated to stem the recent tide of major pension plan sponsors exiting the hedge fund investment category after experiencing disappointing returns.

Efficiently Inefficient is designed partly as a textbook and devotes some space to defining such basic terms as “fundamental analysis,” “margin of safety,” and “sector rotation.” Even seasoned practitioners, however, will benefit from the author’s knowledgeable commentary on the finer points of active management. For example, Pedersen expertly addresses implementation shortfall, the divergence between real-life performance and performance in a perfect world without transaction costs. Not only do real-life fund managers incur explicit transaction costs, he explains, but they also alter their trading patterns to reduce transaction costs and, consequently, miss certain opportunities. Minimizing the shortfall entails a balancing act between trading faster, which increases transaction costs but reduces missed opportunities, and trading more patiently, which has the opposite effects. Carrying the analysis one step further, the author observes that fast trading is appropriate for strategies with large alpha decay — that is, strategies in which the opportunities disappear quickly — whereas patient trading is optimal in illiquid markets.

Although meticulously researched on the whole, Efficiently Inefficient missteps on a few well-worn quotations. According to the author, John Maynard Keynes (1883–1946) coined the aphorism, “The market can remain irrational longer than you can remain solvent.” In reality, the earliest-known citation is from 1993, although the saying may have been current in the 1980s; no mention of Keynes in connection with it has been found prior to 1999. The celebrated felon Willie Sutton denied saying that he robbed banks because that was where the money was, which suggests that the remark was the invention of a journalist. Finally, Herbert Spencer, not Charles Darwin, coined the phrase “survival of the fittest.”

These minor imperfections do not diminish the usefulness of Efficiently Inefficient. It is encyclopedic in its cataloging of active management strategies and authoritative in its analysis of the practical issues of their implementation. Pedersen grounds his exposition in landmark scholarly articles and, where quantitative analysis is required to elucidate a concept, conveys his message without resorting to arcane mathematics. The book should prove especially valuable to institutional investors in deciding which strategies to pursue within their allocations to alternative investments.

More book reviews are available on the CFA Institute website or in the CFA Institute Financial Analysts Journal®.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Martin Fridson, CFA

Martin Fridson, CFA, is, according to the New York Times, “one of Wall Street’s most thoughtful and perceptive analysts.” The Financial Management Association International named him its Financial Executive of the Year in 2002. In 2000, Fridson became the youngest person ever inducted into the Fixed Income Analysts Society Hall of Fame. He has been a guest lecturer at the graduate business schools of Babson, Columbia, Dartmouth, Duke, Fordham, Georgetown, Harvard, MIT, New York University, Notre Dame, Rutgers, and Wharton, as well as the Amsterdam Institute of Finance. Fridson’s writings have been praised widely for their humor, rigor, and utility. He holds a BA in history from Harvard College and an MBA from Harvard Business School.

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