Can Market Inefficiencies Be Exploited?

(MoneyWatch)  "For some months now, Jeremy Grantham, a respected market strategist with GMO, an institutional asset management company, has been railing about -- of all things -- the efficient market hypothesis." So began Joe Nocera's June 5 article in the New York Times. Grantham's argument was that the efficient market hypothesis -- which describes markets as being rational and efficient -- was wrong.

While the debate rages on about whether the markets are efficient, the real question for your investments is whether active managers can exploit inefficiencies and deliver higher returns after expenses. So I pulled out my trusty videotape to check Grantham's record for the past five years through when the article ran. Using data from Morningstar, I compared the returns of five GMO domestic equity funds and two emerging markets funds to good, old-fashioned index funds from Vanguard. (Please note: Vanguard does not have a comparable emerging markets fund, so I used Dimensional Fund Advisors' emerging markets value fund as the benchmark.)

Value stocks

• GMO U.S. Intrinsic Value -- -3.0 percent
• Vanguard Index Trust Value Index -- -0.9 percent

Small-cap value stocks

• GMO U.S. Small/Mid Cap Value -- -3.1 percent
• Vanguard Index Trust Small-Cap Value Index -- 0.5 percent

Small-cap growth stocks

• GMO U.S. Small/Mid Cap Growth -- -3.6 percent
• Vanguard Index Trust Small Cap Index -- 0.8 percent

Domestic growth stocks

• GMO U.S. Growth -- -3.4 percent
• GMO U.S. Core Equity -- -2.0 percent
• Vanguard Index Trust S&P 500 Index -- -1.6 percent
• Vanguard Index Trust Total Stock Market Index -- -0.8 percent

Emerging market stocks

• GMO Emerging Countries -- 14.1 percent
• GMO Emerging Markets -- 15.0 percent
• DFA Emerging Markets Value -- 20.3 percent

There certainly doesn't seem to be any evidence of Grantham's ability to exploit the supposed inefficiencies he is railing about. Thus, it seems Grantham and his investors would be better off investing as if there were no inefficiencies.

As a final point about exploiting market inefficiencies, consider the following about University of Chicago professor Richard Thaler. Thaler is a leading behavioral finance theorist, who studies the very efficiencies Grantham is discussing. In a 2004 Wall Street Journal article, "he concedes that most of his retirement assets are held in index funds. And despite his research on market inefficiencies, he also concedes that 'it is not easy to beat the market, and most people don't.'"