Efficiently Inefficient
Construction under real frictions, funding and liquidity constraints.
Summary
Pedersen, a finance professor who also works at AQR, argues that markets are inefficient enough to reward active management and efficient enough that only skilled managers with real advantages capture the reward. The book is a survey of the strategies that professional investors actually run, with the academic evidence for each.
The coverage is organised by strategy. Market efficiency and the limits of arbitrage set the frame. Then: value and momentum investing, with the evidence on both and Pedersen's argument that they work in combination because their return series are negatively correlated; equity market neutral and quantitative equity, including the August 2007 quant unwind; dedicated short bias; global macro and managed futures, including trend following and carry strategies; fixed income arbitrage; convertible arbitrage; event driven investing including merger arbitrage and distressed. He also covers portfolio construction, risk management, drawdown control, transaction costs and leverage.
A distinctive feature is the interviews with practitioners including Cliff Asness, George Soros, David Harding, John Paulson, Lee Ainslie and Jim Chanos, each attached to the chapter on their strategy.
The book is aimed at advanced students and practitioners and requires finance background. It is the best available single volume mapping what hedge funds do to the academic evidence. Pedersen's affiliation with AQR shapes the treatment of factor investing, which receives more favourable coverage than some competing views would allow, and the factor performance since 2015 has been weaker than the historical evidence presented.
Key takeaways 7
- Markets are inefficient enough to reward skilled active management and efficient enough that unskilled managers cannot capture the reward.
- Value and momentum work well in combination because their returns are negatively correlated, so the combination is more reliable than either alone.
- Liquidity risk is priced across every asset class, and a large share of what appears as alpha is compensation for supplying liquidity.
- Leverage constraints faced by many investors create the low-risk anomaly, since constrained investors bid up high-beta assets and depress their returns.
- Trend following works across asset classes and has done so for a century, and the most credible explanation involves behavioural under-reaction followed by over-reaction.
- Transaction costs and capacity constraints determine whether a documented anomaly is investable, and many published effects vanish once these are included.
- Drawdown control and risk management determine whether a strategy survives to earn its expected return, which makes them part of the strategy rather than an overlay.
Who should read it
Professional investors and advanced students who want a map of active strategies with the academic evidence and practitioner perspective on each.
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Where it sits in the reference 4
Topics