The theory, taught in university finance courses, is that the market is efficient. This hypothesis boils down to investors being unable to consistently beat the market based on available information when making investments.
That theory even lists three levels of efficiency. The lowest level is "weak" informational efficiency. All players in the market know all the information in the public domain; no profit can be wrested from that information.
The "semi-strong" version of the theory says historical information has been fully incorporated into prices. But, says the theory, prices will react immediately to new information. Therefore, no benefit can be gained from a rapid reaction to new information.
The third version is the "strong" one: It assumes that even insider information, to which only insiders at the company are privy, is also incorporated into asset prices.
In reality, the theory doesn't hold up. Empirically, the strong version doesn't work because insider information is the surest and most common way to make money on the stock market. Empirically, the semi-strong version doesn't work either: Nimble investors who are fast on their feet beat the pack.
What about the weak theory? If it worked, there would be no point in equity analysis or in analyzing corporate statements.
The underlying reason the efficient-market theory doesn't hold water is that the market is riddled with vested interests, doctored financial statements, regulatory constraints and weird incentives that propel prices of shares and other financial assets in all directions, except to their "proper price."
No, I'm not about to embark on a list of the Israeli capital market's ills. Not this time.
There is only one way to work in an inefficient, unsophisticated market. Since asset prices are not priced correctly, just find underpriced assets and buy them, or overpriced ones and short them.
Here are some barriers to efficiency in the Israeli capital market, and ways a daring investor can take advantage of them:
1. As institutionals scramble to cover their rears, opportunity beckons.
Institutional investors as a rule don't get into bonds issued by small companies, or ungraded bonds. They prefer to put their depositors' money into investment-grade debentures issued by big companies.
The interest of institutional investors' investment committees is clear. Lacking the capacity to analyze corporate debentures properly, they rely entirely on the credit rating agencies and don't touch bonds that haven't been vetted by those agencies' analysts. Whether the bond looks attractive or not, that external grading, and the fact that the issuer is a big company, suffices to cover their rears.
In any case, they have no vested interest in dealing with bonds or shares of piddling little companies. Since they could only invest a tiny fraction of their assets under management in such minnows, even a wildly successful investment wouldn't affect their total returns. Conversely, failure wouldn't move their yields either, but it would be embarrassing if the target company went belly-up or defaulted on debt. No investment committee chairman wants that on his resume.
The result is that bonds issued by small-cap companies, certainly ungraded ones, have hardly any buyers and can therefore - sometimes - be had at bargain-basement prices. A few players specialize in analysis of securities like these. The Yelin-Lapidot investment house is one. Some have done well by this method.
2. The watchdog frightened the institutionals, who dumped ETNs, creating opportunity to get into their underlying assets.
A rather similar scenario, of goodies lying about to be picked, could arise in the days and weeks to come thanks to a decision by the Finance Ministry's commissioner of capital markets, Oded Sarig. Last week the commissioner prohibited institutional investors from passing their costs of investing in exchange-traded notes on to their customers. The institutionals have to cover ETNs' management fees out of pocket, Sarig ruled.
Exchange-traded notes are a method for investors to invest in a benchmark. One may track the TA-25 index, another commodity prices, another Tokyo's Nikkei index, and so on. The notes' returns are linked to the underlying benchmark or strategy, minus management fees.
When investors buy ETN units, the underwriting investment house pays the gains accrued by the note until it matures, minus the fees. Now Sarig is telling the investment houses that put customer money into ETNs to give the gains to the customers (whose money was used to buy the units) and shoulder the fees. Naturally, the institutional investors found that unacceptable. So they promptly dumped their ETN holdings.
As the ETN holdings washed over the market, the underwriters who had issued the ETNs had to dump the underlying assets. If for instance they had holdings in ETNs tracking the TA-100 index, then suddenly there was a glut of shares listed on the TA-100 index seeking buyers. The upshot was a steep drop in the assets underlying the notes.
And from this soupy mess, two opportunities glisten.
The first is to pick up securities that were indiscriminately dumped before they get bought back directly, not through ETNs. The second is, again, to look at the smaller companies. If the institutional investors are eschewing ETNs, they have no tool to buy an entire index in a single instrument and may simply forgo small-cap investments that could prove to be underpriced.
3. Fly beneath the big boys' radar.
What will happen when management fees fall? Note the dramatics that surrounded the forced cut of management fees for provident funds. The Finance Ministry wanted to lower the maximum price an investment house could charge for managing a provident fund to 1.2% of assets a year. The Knesset went further: 0.7% is plenty, said the MKs. The investment houses wailed that fees that low would ruin the business and the market.
If they're right, the result will be consolidation, ending in a more concentrated, less competitive market controlled by a few big boys that slashed costs, including by paring their analytical departments to the bone. The little players will disappear.
That would be bad for the public, of course. It would get a smaller range of indistinguishable products, like eating at McDonald's rather than specialty cuisine restaurants.
But if you live in a city where all the restaurants are McDonald's, opportunity beckons to the nifty restaurateur offering an intriguing alternative. The Israeli capital market will proffer opportunities to identify securities and business strategies that flew below the radar of the big boys.
4. When everybody's tracking the index, maybe try somewhere else.
A big opportunity on the capital market is the bastard child of a warped incentives system among the investment managers that control the Israeli capital market.
Naïfs might think otherwise, but investment managers have no real interest in the absolute returns of a given client portfolio. Since the investment manager gets paid the same however well (or badly ) the portfolios do, what he really wants is not to lose his job.
Our investment manager can make sure of that by not making courageous or even noteworthy decisions that could go badly. Since all investment managers have the same incentive - to stay put - they will find themselves choosing the same strategy and all will perform about average.
Investment managers like it that way. None get fired and none underperform the pack, and never mind if that mediocre, average performance is terrible for clients.
Since investments are measured against benchmarks, this structure of incentives drags the whole market to converge on the same benchmark. If an investment manager's portfolio does roughly the same as the benchmark, or even a bit less, he'll get his bonus.
How does one achieve the same returns as the benchmark? Imitate it, that's how: Buy the same assets or securities. On Wall Street they call it "closet indexing."
For the client, closet indexing is a lousy strategy. The investment manager charges a significant fee while the client could have done better by sticking his money into an exchange-traded fund that passively tracks the benchmark. He'd get the same returns and save the fee (ETF management companies typically charge very low fees ).
But herein lies an opportunity.
If everybody's trying to track a benchmark and they're putting all the money into its underlying assets - the stocks or whatever securities comprise that benchmark - there may be a chance to spot cheap merchandise in securities that aren't in that benchmark, or that constitute a very small part of it.
