Glimpse of "Convergence to Efficiency" By Will McClatchy December 13, 2001

A new study "Evidence on the Speed of Convergence to Market Efficiency" by Prof. Richard Roll of UCLA and colleagues demonstrates just how quickly competition squeezes out easy profits and offers glimpses of the complexity of equity markets.

It is a curious fact that the S&P 500 often sees persistent order imbalances, where purchase orders exceed or undershoot sell orders for many days at a stretch. And yet returns from one day to the next are serially uncorrelated, virtually a random walk. It is very hard to profit from knowledge of yesterday's returns. Clearly trading activities in the middle of each day are removing inefficiencies, but how fast and in what patterns?

It all starts with the actions of investors who pile on orders and create order imbalance, said Roll, whose study with Tarun Chordia of Emory University and Avanidhar Subrahmanyam of UCLA zeroed in on twenty large and twenty mid-cap stocks from 1996 to 1998. Roll recently presented findings to the Super Bowl of Indexing in Phoenix. "Astute traders see where people are going and jump in with countervailing trades," he said. "Initial price pressure is offset increasingly as the day goes on."

This does take time, but not much. Within ten minutes serial correlation of returns is noticeably reduced and continue to drop at 15 and 30 minutes, and by 60 minutes this is no longer information that may be exploited..

This study has something of interest for every type of investment thinker. For the efficient market theory enthusiast, it is an important demonstration of how markets transition from inefficiency to a weak form of efficiency in minutes. The weak form is achieved because at least simple serial correlation does not signal that easy profits can be made:

"The concepts of market efficiency as defined by Fama in his seminal review [1970], weak, semi-strong or strong efficiency represent a road map for statistical tests. They offer little insight about market processes that might deliver the hypothesized phenomena. Clearly, efficiency does not just congeal from spontaneous combustion. It depends, somehow, on individual actions."

For the more concrete investment thinker who prefers to study patterns of competition to understand where arbitrage profits may be had in a particular market, this study suggests that only full-time, professional traders can play the arbitrage game, and even then they had best be fleet of foot.

"Infra-marginal active investors pay to become better informed and somehow move prices enough that passive investors can enjoy a free ride without sacrificing much return (indeed, any return at the margin.)"

For the thinker who prefers to compare markets with evolutionary biology, the study shows unmistakable traces of "hawks" and "doves". The hawks, or traders, can only exist when doves, or apparently naive long-term investors, exist in ample amounts. Hawks work harder at their role but can pick up extra bits of nourishment, and they keep each other in check. "The evolutionary model says there will be a transition to efficient markets," said Roll.

The paper may be viewed in its entirety here.