Why are markets not (macro) information efficient?
The principal obstacles to information efficiency are costs, trading restrictions, and external effects. In their seminal article “On the Impossibility of Informationally Efficient Markets” Grossman and Stiglitz explained that since price-relevant information comes at a cost it will only be procured to the extent that inefficient markets allow translating it into sufficient returns: ” The only way informed traders can earn a return on their activity of information gathering, is if they can use their information to take positions in the market which are ‘better’ than the positions of uninformed traders…Hence the assumptions that all markets, including that for information, are always in equilibrium and always perfectly arbitraged are inconsistent when arbitrage is costly” (view journal article here). This theory shows what practitioners already know: investment in information involves a trade-off between cost and return, with no guarantee that markets set asset prices close to their fundamental value.
Acknowledging the cost-return trade-off, the theory of rational inattention provides a model of how market participants manage their scarcity of attention (view post here). In general, people cannot continuously process and act upon all information, but they can set priorities and choose the mistakes they are willing to make. Rational inattention explains why agents pay disproportionate attention to popular variables, simplify the world into a small set of indicators, pay more attention in times of uncertainty, and limit their range of actions.
Theory and practice show that investment managers only collect information and engage in research if costs are contained, if the overall market is not already well informed, and if the information advantage can remain confidential:
- First, information cost must not exceed related expected returns. Genuine value-generating macroeconomic and financial research requires experience, quantitative skills and systems, and a lot of legwork. This means that information costs easily add up to large numbers in practice. Many essential areas of this research, such as real-time economic data or advanced modeling, are beyond the scope of most portfolio management teams, even at large institutions. Thus, standard economic data are notoriously hard to interpret and require considerable adjustments. Economists often disagree on their interpretation of data and do not normally update their predictions continuously. Even the most popular and highest-quality economic data, such as U.S. labor market reports, need in-depth research to extract information (view post here). Also, forecasts are also not easily comparable across countries due to different conventions and biases. All this gives rise to rational information inattentiveness of markets (view post here). This means that market participants update their information set sporadically, rather than continuously. Rational inattentiveness reflects costs of acquiring information or costs of re-optimizing investment decisions. There is empirical evidence that inattentiveness causes sticky expectations and goes some way in explaining price momentum after important relevant news, such as corporate earnings releases (view post here). Moreover, understanding the relationship between economic information and asset prices requires experience and econometric skills. Data science has come a long way in providing powerful tools for analysis and model construction. However, in the data-constrained macro space, the success of statistical models hinges on good judgment and real in-depth understanding of methods, models, and data, all of which remain in short supply. Therefore, most, institutional investors prefer simple relations, often condensed in the three main categories of risk premia strategies, i.e. carry, momentum, and relative value (view post here).
- Second, investor research only pays off when the overall market is not already well informed. Put simply, research must result in a significant information advantage. This can be a serious obstacle because the information content of prices with respect to known fundamentals tends to grow faster than the information content of private research. This discourages fundamental research and can lead to over-reliance on price information (view post here). Experimental research has confirmed that traders do not invest in information if they believe that others have already done so and that market prices already reflect this research (view post here). For a profitable investment management business, it is crucial to invest in relevant information where or when others do not.
- Third, the information advantage must remain confidential. In particular, market makers must not suspect that their counterpart is in possession of superior information (view post here). A value trader with a reputation of being well informed is easily ‘front run’ when giving orders to market makers. As pointed out by Bouchaud, Farmer and Lillo (2009): “If I know that you are rational, and I know that you have different information than I have, when I see you trade and the price rises I can infer the importance of your information and thus I should change my own valuation.”
Moreover, research alone does not produce efficient markets. Financial markets research translates into price information only if it is acted upon. Alas, the link between research and actual investment flows is often tenuous, for various reasons.
- Taking positions in accordance with research is frequently obstructed by institutional rules and regulations. For example, many funds face limitations to leverage and short selling or are prohibited from investing in specific asset classes, currencies, and sectors.
- For some institutions market access is limited and trading costs can be prohibitively high. For example, in OTC (over-the-counter) markets bid-offer spreads vary across counterparties(view post here), favoring clients with high volumes and sophistication. Since institutional investment strategies in forwards, swaps, and options that are sensitive to transaction cost implementation depends on the institution’s standing with market makers.
- Often enough investment managers simply do not fully trust their researchers, possibly due to conflicts of interest. Portfolio managers sometimes denigrate research to elevate their own role in profit generation. Researchers sometimes gear their research towards company politics and reputation rather than investment value.
- Finally, there is evidence that financial decision-making under uncertainty is far from rational and subject to a range of behavioral biases, such as the illusion of control, anchoring bias, sunk-cost bias, and gambler’s fallacy (view post here). This implies irrational neglect of optimal strategies.
Even if some market participants have superior information and do rationally trade on it, there is no guarantee that their trading will make the overall market more information efficient. As Markus Brunnermeier (2005) illustrated: “While information leakage makes the price process more informative in the short-run, it reduces its informativeness in the long-run…A trader who receives a noisy signal about a forthcoming public announcement can exploit it twice. First, when he receives it, and second, after the public announcement since he knows best the extent to which his information is already reflected in the pre-announcement price. Given his information he expects the price to overshoot and intends to partially revert his trade.” In summary, “obstructions to information diffusion” are common. This means that relevant information and research translate into gradual price trends rather than instantaneous price adjustments (view post here). Gradual diffusion directly conflicts with Eugene Fama’s requirement that an “efficient market is a market which adjusts rapidly to new information.”. Indeed, sluggish price adjustment seems to go a long way in explaining unexpected deviations of financial markets from a rational expectations equilibrium, including the many so-called ‘puzzles’ in the foreign exchange market (view post here).