NEW YORK — Efficient market theory still works, according to Nobel Prize winner Robert Merton and prominent finance academic Zvi Bodie.
That's important to money managers, who have been increasingly looking to quantitative management over the past three years to produce excess returns.
Behavioral finance theorists have criticized efficient market theory, citing the massive tech-stock bubble of the late 1990s as a prime example of its flaws. But the two academics argue that conflicting aims and choices made by investors balance each other out.
The market ultimately sets the correct price for securities, despite the existence of short-term anomalies and irrational investment decisions made by individuals, the authors wrote in a paper to be published in the Journal of Investment Management next month. Messrs. Bodie and Merton are finance and economics professors at the Boston University School of Management and Harvard Business School, respectively.
"This is one of the best papers I've read in a long time," said Richard Michaud, whose firm, New Frontier Advisors LLC, Boston, won two patents from the U.S. government for its optimization processes. "The value for me in this paper is that it represents a new way of mitigating the objections to neoclassical finance. This paper is a wonderful mix of examples of how to overcome the challenges of neoclassical finance and how neoclassical finance finds its way."
Andrew Lo, director of financial engineering at the Sloan School of Management at the Massachusetts Institute of Technology, Cambridge, also lauded the paper. "I guess for me it's a great paper because it underscores the nature of function. The one thing that is rather fixed and immutable is the various functions" of investors.
Mr. Bodie and Mr. Merton originally developed their "functionality" thesis in their 1995 book, "The Global Financial System: A Functional Perspective," in which they asserted that while financial institutions change, their basic functions remain relatively stable. They outline the six basic functions of an institutional investor as: clearing and settling payments; pooling resources and subdividing shares; transferring resources across time and space; managing risk; providing information; and dealing with problems pertaining to incentive.