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Pedersen - Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined

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Pedersen Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined
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Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined: summary, description and annotation

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Efficiently Inefficient describes the key trading strategies used by hedge funds and demystifies the secret world of active investing. Leading financial economist Lasse Heje Pedersen combines the latest research with real-world examples and interviews with top hedge fund managers to show how certain trading strategies make moneyand why they sometimes dont.

Pedersen views markets as neither perfectly efficient nor completely inefficient. Rather, they are inefficient enough that money managers can be compensated for their costs through the profits of their trading strategies and efficient enough that the profits after costs do not encourage additional active investing. Understanding how to trade in this efficiently inefficient market provides a new, engaging way to learn finance. Pedersen analyzes how the market price of stocks and bonds can differ from the model price, leading to new perspectives on the relationship between trading results and finance...

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EFFICIENTLY INEFFICIENT EFFICIENTLY INEFFICIENT How Smart Money Invests and - photo 1

EFFICIENTLY INEFFICIENT

EFFICIENTLY INEFFICIENT

How Smart Money Invests and Market Prices Are Determined

LASSE HEJE PEDERSEN

PRINCETON UNIVERSITY PRESS

PRINCETON AND OXFORD

Copyright 2015 by Princeton University Press

Published by Princeton University Press, 41 William Street, Princeton, New Jersey 08540 In the United Kingdom: Princeton University Press, 6 Oxford Street, Woodstock, Oxfordshire OX20 1TW

press.princeton.edu

Jacket art akindo/Getty Images

All Rights Reserved

Library of Congress Cataloging-in-Publication Data

Pedersen, Lasse Heje.

Efficiently inefficient : how smart money invests and market prices are determined / Lasse Heje Pedersen.

pages cm

Includes bibliographical references and index.

ISBN 978-0-691-16619-3 (hardcover : alk. paper) 1. Investment analysis. 2. Investments. 3. Portfolio management. 4. Capital market. 5. SecuritiesPrices. 6. Liquidity (Economics) I. Title.

HG4529.P425 2015

332.6dc23

2014037791

British Library Cataloging-in-Publication Data is available

This book has been composed in Sabon Next LT Pro and DINPro

Printed on acid-free paper.

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

Contents

The Main Themes in Three Simple Tables

OVERVIEW TABLE I. EFFICIENTLY INEFFICIENT MARKETS

Market Efficiency

Investment Implications

Efficient Market Hypothesis:

Passive investing:

The idea that all prices reflect all relevant information at all times.

If prices reflect all information, efforts to beat the market are in vain. Investors paying fees for active management can expect to underperform by the amount of the fee.

However, if no one tried to beat the market, who would make the market efficient?

Inefficient Market:

Active investing:

The idea that market prices are significantly influenced by investor irrationality and behavioral biases.

If prices bounce around with little relation to fundamentals due to investors being nave, beating the market would be easy.

However, markets are very competitive, and most investment professionals do not beat the market.

Efficiently Inefficient Markets:

The idea that markets are inefficient but to an efficient extent. Competition among professional investors makes markets almost efficient, but the market remains so inefficient that they are compensated for their costs and risks.

Active investment by those with a comparative advantage:

A limited amount of capital can be invested with active managers who can beat the market using a few economically motivated investment styles.

This idea underlying the book provides a framework for understanding why certain strategies work and how securities are priced.

OVERVIEW TABLE II. HEDGE FUND STRATEGIES AND GURUS

Classic Hedge Fund Strategies

Gurus Interviewed in This Book

The profit sources for active investment

Who personify the classic strategies

Discretionary Equity Investing:

Lee Ainslie III:

Stock picking through fundamental analysis of each companys business.

Star Tiger Cub and stock selector.

Dedicated Short Bias:

James Chanos:

Uncovering companies with overstated earnings or flawed business plans.

Legendary financial detective who shorted Enron before its collapse.

Quantitative Equity:

Cliff Asness:

Using scientific methods and computer models to buy and sell thousands of securities.

Quant luminary and a pioneer in the discovery of momentum investing.

Global Macro Investing:

George Soros:

Betting on the macro developments in global bond, currency, credit, and equity markets.

The macro philosopher who broke the Bank of England.

Managed Futures Strategies:

David Harding:

Trend-following trades across global futures and forwards.

Devised a systematic trend-detection system.

Fixed-Income Arbitrage:

Myron Scholes:

Relative value trades across similar securities such as bonds, bond futures, and swaps.

Traded on his seminal academic ideas that won the Nobel Prize.

Convertible Bond Arbitrage:

Ken Griffin:

Buying cheap illiquid convertible bonds and hedging with stocks.

Boy king who started trading from his Harvard dorm room and built a big business.

Event-Driven Arbitrage:

John A. Paulson:

Trading on specific events such as mergers, spin-offs, or financial distress.

Event master with the subprime greatest trade ever.

OVERVIEW TABLE III. INVESTMENT STYLES AND THEIR RETURN DRIVERS

Investment Styles

Ubiquitous methods used across trading strategies

Return Drivers

Why these methods work in efficiently inefficient markets

Value Investing:

Buying cheap securities with a low ratio of price to fundamental valuee.g., stocks with a low price to book or price-earnings ratiowhile possibly shorting expensive ones.

Risk premiums and overreaction:

A security that has a high risk premium or is out of favor becomes cheap, especially when investors overreact to several years of bad news.

Trend-Following Investing:

Buying securities that have been rising while shorting those that are falling, i.e., momentum and time series momentum.

Initial underreaction and delayed overreaction:

Behavioral biases, herding, and capital flows can lead to trends as prices initially underreact to news, catch up over time, and eventually overshoot.

Liquidity Provision:

Buying securities with high liquidity risk or securities being sold by other investors who demand liquidity.

Liquidity risk premium:

Investors naturally prefer to own securities with lower transaction costs and liquidity risk, so illiquid securities must offer a return premium.

Carry Trading:

Buying securities with high carry, i.e., securities that will have a high return if market conditions stay the same (i.e., if prices do not change).

Risk premiums and frictions:

Carry is a timely and observable measure of expected returns as risk premiums are likely to be reflected in the carry.

Low-Risk Investing:

Buying safe securities with leverage while shorting risky ones, also called betting against beta.

Leverage constraints:

Low-risk investing profits from a leverage risk premium as other investors demand high-risk lottery assets to avoid using leverage.

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