How Does an Inefficient Market Get That Way?

In an efficient market, the actions of intelligent, informed, diligent and objective

investors case assets to be !riced fairly based on the available information sch that
their !ros!ective retrns are in !ro!ortion to their risk" #o bargains are available, and the
only way to increase e$!ected retrn is to take on more risk"
%t in an inefficient market, this !rocess breaks down" The !rere&isites for efficiency
are not flly satisfied, and ths !rices are able to diverge from what they 'shold' be"
(ome assets become over!riced and othersnder!riced" )rofits can be earned by
a!!lying skill, not jst for bearing risk" It becomes !ossible to consistently achieve
s!erior risk*adjsted retrns"
%t how does a market get that way? There are many !ossible reasons" Maybe most
investors ignore the market niche becase itis little known" )erha!s information is
skim!y or nevenly disseminated" Marketinfrastrctre may be nder*develo!ed, so
trading difficlties scare investors away" Maybe there+s no trade re!orting, so (eller ,
doesn+t know what % got jst a few mintes earlier and settles for less" The list of
!ossible reasons goes on and on, btwe have or own favorite- Investors fail to act
objectively and dis!assionately"
,n efficient market mst be nbiased" That is, the !artici!ants mstbe motivated jst by
economics and willing to either by or sell de!ending on !rice" If every owner wants to
.or mst/ sell a given good and won+t become a byer no matter how low the !rice goes,
the !rice of that good can fall below the 'fair'level and it will become !ossible to find
bargains" 0onversely, !rices can go too high when everyone wants to own something " " "
whether it+s tli! blbs, (oth (ea !earls or nifty*fifty stocks"
,nd that brings s to the high yield bond market which remains, in or o!inion,
decidedly inefficient" High yield bonds contine to offer 123*433 basis !oints more yield
than 'riskless' Treasry bonds to com!ensate for the risk of losing 23*523 basis !oints
!er year to credit !roblems" ,nd high yield bonds have the best !erformance record of
any major sector of the fi$ed income niverse for virtally every !eriod throgh today"
6ne wold certainly e$!ect these facts to attract byers and raise !rices"
In 5784, I was sre this market wold become efficient in five years" %t it hasn+t done
so ten years later, des!ite the high historic and !ros!ective retrns" Why haven+t enogh
byers ste!!ed forward to eliminate the e$cessive risk !remim, render these bonds
fairly !riced and correct the inefficiency?
9 6aktree 0a!ital Management, :")"
,ll ;ights ;eserved
The answer, we feel, is sim!le- investors contine to be nfairly !rejdiced against
them" #ot every investor, clearly, bt enogh big !layers to create a byers+ market and
tilt the o!!ortnity in favor of those who are willing to !artici!ate"
)rove it, yo say? Well, this memo was occasioned by an article in ')ensions <
Investments' re!orting consltant (=I+s recommendation that !ension !lan s!onsors
invest 53> to 13> of their fi$ed income !ortfolios in high yield bonds" ,s I went
throgh the article, my reaction was that it was a great selling !iece for or market sector
** not jst (=I+s recommendation, bt what the article demonstrated abot investor
attitdes"
,ccording to the article, (=I feels 'a s!onsor cold add abot ?3 basis !oints of retrn
withot adding risk by !tting 53> of its fi$ed income !ortfolio in high yield, or jnk,
bonds"' ,nd that+s after (=I 'tried to be as conservative as !ossible in its assm!tions"'
I+m sold@ %t the article goes on to show howa market can be biased against an asset
class-
" " " High yield is !erceived as a way to add diversification, bt is not wellreceived by clients"
'#ot a lot of or clients are o!ting to se them " " " "
We work with some clients who jst !lain don+t want them in their
!ortfolio"' .0allan/
%ecase of the negative !blicity srronding high yield bonds arond the trn of
the decade, !lan s!onsors either are wary of investing in them, or are afraid of
being associated with them" .)ensions < Investments/
(ome !lan s!onsors may be limited by !lan gidelines to investment*grade
secrities, " " " 6ther s!onsors may be wary of jnk bonds becase of the market+s
well*!bliciAed colla!se in 5787 and 5773, and the secrities+ association with
Michael Milken and the now*defnct bond hose Dre$el %rnham :ambert"
.(=I/
If we+re going to worry abot a colla!se, I ho!e it+ll be one looming ahead, not one which
occrred five years ago" The asset class that colla!sed in the !ast is likely to be chea!,
not to be riding a crest of !o!larity and ths heading for a fall"
%t too many investors drive looking in the rear*view mirror" ,s someone at my former
!lace of em!loyment once told clients, 'We+rebying the oilsB they+ve been good to s"'
We+d rather by what has !erformed badly or is the sbject ofnegative bias and ths is
chea!" We feel strongly thathigh yield bonds &alify today, and we+d be glad to talk
more abot them, or abot the o!!ortnities in other areas"
9 6aktree 0a!ital Management, :")"
,ll ;ights ;eserved
:egal Information and Disclosres
This memorandm e$!resses the views of the athor as of the date indicated and sch views
are
sbject to change withot notice" 6aktree has no dty or obligation to !date the information
contained herein" Crther, 6aktree makes no re!resentation, and it shold not be assmed, that
!ast investment !erformance is an indication of ftre reslts" Moreover, wherever there is the
!otential for !rofit there is also the !ossibility of loss"
This memorandm is being made available for edcational !r!oses only and shold not be
sed
for any other !r!ose" The information contained herein does not constitte and shold not be
constred as an offering of advisory services or an offer to sell or solicitation to by any
secrities or related financial instrments in any jrisdiction" 0ertain information contained
herein concerning economic trends and !erformance is based on or derived from information
!rovided by inde!endent third*!arty sorces" 6aktree 0a!ital Management, :")" .D6aktreeE/
believes that the sorces from which sch information has been obtained are reliableB however,
it
cannot garantee the accracy of sch information and has not inde!endently verified the
accracy or com!leteness of schinformation or the assm!tionson which sch information is
based"
This memorandm, inclding the information contained herein, may not be co!ied, re!rodced,
re!blished, or !osted in whole or in !art, inany form withot the !rior written consent of
6aktree"