The Little Book of Hedge Funds

Chapter Six

Ironing Out Inefficiencies

Exploiting the Efficient Market Theory

If the efficient markets hypothesis was a publicly traded security, its price would be enormously volatile.

—Andrei Shleifer and Lawrence H. Summers, The Noise Trader Approach to Finance

In 1990, Andrei Shleifer and Larry Summers mockingly made the comment that begins this chapter, adding that the “stock in the efficient markets hypothesis—at least as it has been traditionally formulated—crashed along with the rest of the market on October 19, 1987 . . . and its recovery has been less dramatic than that of the rest of the market.”1 Pretty fun for a pair of economists from Harvard, especially for one who would serve as President Clinton’s Secretary of the Treasury and President Obama’s Director of the White House National Economic Council.

Why is this important to a Little Book about hedge funds? Essentially, hedge funds attempt to exploit the fact that markets are inefficient—it’s their bread and butter. Thus, their activity helps drive markets closer to the efficient market theory. For the most part, though, markets have giant inefficiencies that create huge profit opportunities for those who are willing to take some risks. This finding has a huge impact on hedge funds, because in a world of inefficiency there seems to be endless ways to make money and maximize returns. It simply requires the ability to look at things in a different way . . . a contrarian way.

A Kid in a Candy Store

From the time of ...