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

by Lasse Heje Pedersen

Financial market behavior and key trading strategies―illuminated by interviews with top hedge fund experts

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 money―and why they sometimes don't.

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 theory. He explores several different areas in depth―fundamental tools for investment management, equity strategies, macro strategies, and arbitrage strategies―and he looks at such diverse topics as portfolio choice, risk management, equity valuation, and yield curve logic. The book’s strategies are illuminated further by interviews with leading hedge fund Lee Ainslie, Cliff Asness, Jim Chanos, Ken Griffin, David Harding, John Paulson, Myron Scholes, and George Soros.

Efficiently Inefficient effectively demonstrates how financial markets really work.

Free problem sets are available online at

Genres: Finance, Economics, Business, Nonfiction, Money

368 pages, Hardcover

First published April 4, 2015

Reviews

[3thn · Rating 5 out of 5]

Coming from having near zero finance background, this was a great, insightful guide on how money moves around the world through simple explanations backed by equations and charts. While I doubt any financial strategy listed in a textbook will still be worthy, this book outlines the overall categories of types of trades and perspectives different types of money managers take. It seems neutral, getting perspectives from almost every angle. It lets you know what you don't know.

I also love how at the end of every chapter he personally interviews famous giants in the financial space such as Soros, the person who broke the Bank of England, Paulson who shorted the 08 crisis, Scholes, who created the celebrated Black-Scholes equation, and pretty much everyone who is a household name.

[Justus · Rating 1 out of 5]

This book comes from a set of lecture notes and it certainly feels that way. If you have read much in investing you aren't likely to find enough here to be worth the effort of digging. If you are brand new to investing and for reason want to learn about managed futures...then I guess this is a good first overview?

The first several chapters contain an introduction to several mathematical concepts used in finance. They are introduced with a rapidity that is likely too fast for casual readers. And they aren't used again anywhere else in the book. Unless you need to know about this stuff for homework in Pedersen's class, you can safely skip the first 100 pages.

This introduction isn't bad per se but it is a taste of the fundamental problem with the book. It introduces a lot of concepts but without much depth. This is especially highlighted in the first "real" chapter, which is about value investing. Is there a more overdone topic in investing literature? Pederson doesn't offer anything that hasn't been done better a hundred times. What's more, it is pretty basic stuff. "Value investors look at fundamentals and try to find underpriced companies." If you want a more up to date take on value investing, check out Quantitative Value.

The next chapter, about shorting, is more of the same. "Shorts look for companies that are overvalued and short them. They do this by researching stuff."

There are brief case studies, such as the manager who shorted Enron. There are brief interviews with managers in each style. The interviews are much like post-game locker room interviews. Full of bromides with little insight. Here's what Lee Ainsle says about his value investing:

"To oversimplify, we are really trying to look out two or three years in every industry in which we invest, trying to identify who's winning and losing, and perhaps most importantly, recognize the discrepancies between our view and the view of the markets.

"We have a very deep and thorough process."

Do you think there are many investors -- of any stripe -- who are going to say anything substantially different?

Ultimately, this felt like it lands in a weird spot and I'm not sure who, other than graduate finance students, are the target audience. At times (especially in the beginning) it is extremely technical. Far too technical for a casual reader who doesn't know anything about value investing or shorting or whatever. But in the individual chapters, it is strangely rudimentary and many even moderately seasoned investors will need to skip sections.

[Daniel Hold · Rating 4 out of 5]

I learned a lot

[Luciano · Rating 5 out of 5]

Should be mandatory reading for anyone involved in liquid markets. Pedersen, an academic turned into practitioneer, resorts to an unique and outstanding combination of academic research, practical experience, and networking (he interviews no less than Soros, John Paulson, Scholes, etc., on their areas of expertise) to deliver a single author handbook that can be read from the beginner to the epert (who'll certainly benefit from the extense and dense bibliography). After reading it, I have no doubts left that markets can be beaten, but that takes a lot of work and brainpower.

[Steve · Rating 5 out of 5]

Fantastic book which goes through various strategies used in active management to attempt to beat the market. A very unique read - the author does a fantastic job at explaining concepts, and really fills in the issues regarding the efficient market hypothesis. Each chapter has a discussion at the end from a player in that unique field (i.e. risk merger & bankruptcy arbitrage - John Paulson).

A good read if you're interested in finance and/or hedge funds.

[Andrew · Rating 5 out of 5]

Comprehensive introduction to applied financial economics in which the author outlines major categories of hedge fund trading strategies and their economic underpinnings. Pedersen is an AQR quant, so the book skews mathematical, but this is more than made up for with the interview transcripts.

[InvestingByTheBooks.com · Rating 4 out of 5]

This text is an unusual hybrid of a description of hedge fund investment styles, investor interviews and a finance textbook. The book’s promise is to be a mix of Antti Ilmanen’s Expected Returns (an AQR colleague) and Jack Swager’s “wizard-series”. Efficiently Inefficient doesn’t fully live up to this standard but I still like it.

This hybrid approach isn’t surprising given the author’s parallel and impressive career path. Pedersen is a finance professor at both NYU and Copenhagen Business School and has written several important papers earning him the title of best European economist under 40. Further he’s on the editorial board of The Journal of Finance and a research associate at NBER. For most of us this would be more than enough but this is only half the story. The author is also a principal on AQR’s asset management team and as such an important part of one of the world’s largest hedge funds. This has no doubt given him easier access to the many investors to interview in this book. At least Pedersen has turned 43 by now so even he can’t have it all...

The introductory section on the nuts and bolts of hedge funds (called Active Investment in the typical modest hedge fund style) discusses topics like risk management, back testing, trading, performance measurement etc. I found the notion of several different types of liquidity premiums very interesting and now and then the author presented a nugget I hadn’t thought of but mostly this section gives the foundation for the rest of the book by describing the general character of “smart money” and the activities that hedge funds perform.

The remainder of the book analyzes eight common hedge fund investment strategies: long-short equities, short-selling, quantitative equities, global macro, managed futures, fixed-income arbitrage, convertible bond arbitrage and event-driven investments. Initially the strategy is described from a textbook type of angle and then Pedersen continues to show how they are practiced. The text on each strategy is finally ended with interviews with rock star practitioners like James Chanos, Cliff Asness, George Soros, Ken Griffin, John Paulson and many more.

Despite the author’s high level of understanding he manages to deliver a high quality but also easily understandable guide to the strategies. Pedersen’s theoretical background is in mathematical economics but save one chapter the number of equations is kept fairly low. With a whole spectrum of investment strategies some will surely interest certain readers more and some less. Due to the number of equations in the text and my low interest of investment strategies trying to find arbitrage opportunities among bonds and bills I largely skipped the text on fixed-income arbitrage.

A positive surprise to me was the interview with John Paulson who I’ve seen as a bit reckless going all in on the “greatest trade” in mortgage backed securities and then losing most of the gains on gold. Instead, in the interview on event-driven investment, I found Paulson both reasoning, intelligent and ready to learn from others. I’m further struck by how many of the strategies used and also the language used by hedge funds that has become an integral part of the everyday life of pension funds – no doubt wanting to become a bit more “smart money” themselves.

My main quarrel with the book is that it overpromises to some extent. The main title Efficiently Inefficient and the subtitle How Smart Money Invests & Market Prices are Determined implies a focus on pricing theory where markets are “inefficient but to an efficient extent” so that professional investors are compensated for their work. Well, if you don’t count simply showing how a number of hedge fund investment strategies earn money there is disappointingly little of general discussion on this topic in the book.

Competent, high quality but a little overreaching.

[Chelesa · Rating 5 out of 5]

This book serves as a broad, generic, and systematic overview of the different inefficiencies in various sectors of the market and how investing gurus such as Soros, Buffet, Ainslie have made their careers out of such opportunities. I am certain that there are alternative ways to look at the market, but Lasse Pederson's theory is a beautiful one that is both theoretically sound and behaviorally sensical. Tying the financial markets with philosophy, Eugene Fama's EMH (Efficient Markets Hypothesis) has established a crucial framework in which we analyze and benchmark actual inefficiencies against. To a certain extent, EMH is like Plato's Forms.

Reading this book has also triggered a lot of memories, as it seems that my Behavioral Finance course in undergrad was closely tracking the system of this book. Even some of the key examples were exactly the same. Again, this shows that it is introductory enough for people with limited knowledge of finance, but at the same time useful for someone like me who has been knee-deep in just one small sector (that being fixed income derivatives) to see that the same logic actually could be replicated much more broadly elsewhere in the credit, commodities and equities market as well.

Certain chapters that are harder for me to read include: 1) Arbitrage trading and pricing - Convertible bonds 2) Equities Strategies - Dedicated Short Bias. The macro-driven chapter has to be the closest to me, but even there I have found certain topics quite foreign (sovereign wealth fund spreads), which they should not be. As such, in addition to obtaining a generic, high-level overview, I have also brushed up on product and sector-specific knowledge.

[Juancho Vizcaino · Rating 5 out of 5]

“LHP: Why do spreads tend to widen during some periods of stress?

MS: Well, capital becomes more scarce, both physical capital and human capital, in the sense that there isn’t enough time for intermediaries to understand what is happening in chaotic times. Finance is in volatility time, not calendar time. When times are very quiet, intermediaries have a lot of time to figure things out, ask questions, put on trades, etc. When markets are very volatile, intermediaries don’t have enough calendar time to make decisions. They don’t have enough human capital to throw into the breach. That is why volatility time is so crucial to understand market pricing. As a result, intermediaries withdraw capital from the market. Capital goes to the sidelines until they can figure out whether and how to intermediate. Intermediaries lose on their invested capital because flows go against them as they are reducing risks; they become demanders of liquidity as they have to reduce risk. And, in chaotic markets, institutions and investors demand more intermediation services. Spreads widen, and market prices deviate from equilibrium values. At times of shock, market participants must sort out to what extent equilibrium prices have changed and to what extent supply–demand imbalances have increased. This takes time”.

[Arun Kodumuru · Rating 4 out of 5]

It’s a classic book and written quite well; I just thought there’s room for improvement.

Overall, I loved the concepts that were covered, and as someone more experienced, I was able to revisit material I had previously learned while also capturing new information.

The theoretical information about some areas, such as the Sharpe ratio and graphs about strategy returns, was helpful. However, sometimes I felt like it was unnecessary — specifically when the merger arb correlation equation to CAPM was shown, I thought it distracted me more than provided value.

Additionally, some concepts are explained in a redundant fashion, and I felt it wasn’t necessary to explain every detail. I also thought some of the cooler concepts, like index rebalances or spin-offs, weren’t covered in great detail and could have been.

My favorite part is the interviews, and that’s why it still gets a higher rating. However, these were such a small part of the book, and I would have appreciated more specific questions directed to the investors.

Overall, I think it’s a classic that’s written well but just has some room for improvement.

[Robert · Rating 3 out of 5]

Efficiently Inefficient is a semi-technical survey of buyside finance, explaining how different strategies (e.g long/short equity, quant equity, macro, credit, arb) work, along with interviews of leading practitioners (e.g Ken Griffin, Cliff Asness, John Paulson).

There are lots of useful ideas in the book, some of my favourites: the idea of efficient inefficiency, the equivalence between regressions and backtests, the overview of Soros' theory of reflexivity, the expected returns of different asset classes.

But the big problem is that Pedersen chose a weird level of abstraction to pitch the book at. It's technical and is written in a rather academic way, with a focus on the academic literature more than practical results. The interviews are nowhere near as valuable as those in Market Wizards or Inside the House of Money. As a result, I'm not sure who to recommend this to.

[Aleksander · Rating 4 out of 5]

Mr. Lasse Heje Pedersen creates a great textbook, especially those new to finance, to explore the different realm of funds available in the hedge fund world. He discusses various types of strategies and goes into the detail the different foundational elements and economics that make up each strategy process. Unfortunately - he does not go too in-to depth and sticks to surface level details but overall a great book. Those looking for a shift from the sell-side to buy-side will also find value in the foundational elements that he teaches.

[Abhimanyu Choudhary · Rating 5 out of 5]

A well thought out treatise that reconciles market efficiency and inefficiency while avoiding the screeching and you-know-what flinging that is so commonplace on either sides of the debate. It voices the opinion of the silent (or rather quiet) majority in a precise way: markets are not fully efficient - but they are efficient enough given constraints faced by active managers.

[Michael · Rating 4 out of 5]

Very good overview of hedge funds and different investing strategies. Not too heavy on math and equations but shows enough to keep it interesting. My favorite parts are the interviews with hedge fund managers and experts like Warren Buffet.

[Will · Rating 2 out of 5]

This is about as dry as reading a text book. Maybe if your looking to get into the hedge fund industry this would be a solid book to read. For a retail trader I'm not seeing the worth in reading.

[Drasko Kovrlija · Rating 2 out of 5]

Title is misleading, there is no central theme or hypothesis to this book. It's just a textbook, seemingly written for undergraduate level, that explains various investment strategies of hedge funds.

[Kate · Rating 4 out of 5]

I think the best part is the interviews. The rest is more like a textbook.

[An Do · Rating 4 out of 5]

There's no free lunch, as they say. Especially not in investing.

[Aris Catsambas · Rating 3 out of 5]

Good introduction to financial concepts - found most of it easy to follow, except the chapters on bond arbitrage.

[Mike Gao · Rating 4 out of 5]

Great survey, although on the more technical side, of how academic asset pricing theories translate to real world strategies employed by hedge funds.

[Zaeneas · Rating 5 out of 5]

Pros: A collection of lecture notes
Cons: A collection of lecture notes

[Max Stone · Rating 3 out of 5]

I was tricked! I thought the book would be about the first part of the title (the notion that since markets require active participants to be efficient, and participants have to be rewarded to be active, meta-efficiency requires that markets be a little bit inefficient). I guess I failed to noticed the sub-title, and also that the first notion alone wasn't really book-length material.

At the end of the day, this was a fairly generic book about common investing strategies, focusing on but not limited to common hedge fund strategies. It's got irreverence on one end, and formulas on the other end, and a lot of accurate but somewhat vanilla information in the middle.

I don't think I learned a single non-trivial thing I didn't already know (so it was below 3 stars for my own reading, but I'm a tough audience for this sort of book and I'm trying to adjust for that).

I was impressed at the list of people he interviewed for a view pages on each hedge fund strategy (Lee Ainslie, George Soros, Ken Griffen, James Chanos, etc). A highlight for me was several repetitions of the author asking the interview subject how they knew whether their insight was already in the market price, and the near universal response of "good question!" followed by some form of "you have to work to try to figure that out". It is a good question, in fact.

Probably worth reading if you just got an internship or entry level job at a hedge fund?

I guess one thing I learned was that in college Ken Griffen focused on convertible bonds with hard-to-borrow underlyings, which he could often borrow in retail quantities through his schwab account even though they were institutionally unborrowable. Seems very smart (not surprising that Ken Griffen was smart about cb investing, but still an interesting fact I didn't know)

[Tomas Krakauskas · Rating 4 out of 5]

Great book about different investment strategies. To my mind main value is that author provides not only long track record of different investment strategies, but also in detail explain how they work including more sophisticated ones like convertable bond arbitrage, managed futures, fixed income arbitrage, global macro investing or event driven arbitrage. In each chapter author gives an interview with the leading investor of particular strategy like G. Soros, M. Scholes, J. Paulson and etc.
Even though the book is more like a textbook, but it is not boring and worth to read for industry professionals as it broadens the view and helps to see big picture to understand why different investment styles work and why efficient markets need suchs investors.
One of the best quote in the book, which I will remember "When the crisis abates and the range of uncertainty is reduced, it leads to an almost automatic rebound in the stock market as the liquidity preference stops rising and eventually falls."

[Chris Leuchtenburg · Rating 2 out of 5]

In the early chapters, I thought that I had finally found an explanation of the hedge fund industry with enough technical depth to satisfy my curiosity. The mostly simple equations for risk, alpha and other key concepts enabled me to understand these concepts better. Pedersen rightly defines hedge funds by their relative lack of regulation rather than strictly investment strategies focused on hedging per se. However, when he presents the various investment strategies, they seemed prosaic, without much difference from stock picking or day trading. Much of it, like momentum trading seemed more like shrewd gambling than investment. And the roll of hedging was not clear. I suppose that it should be no surprise that some analysts are now blaming the markets' high volatility on hedge funds, which should have reduced volatility.

[Michael Sperling · Rating 3 out of 5]

A very interesting view into the World of Wall Street. Pedersen writes in the preface that the book can be used by a private investor as well as in universities. I think this is the book's biggest liability (to ude the book's lingo). On one hand he tries to describe different investment strategies and why the market in not efficient, and on the other hand some of the investment strategies are explained in complicated math. This is confusing. However, the individual parts being the math, the explanation of why market is efficiently inefficient and the interviews are very interesting.

[Sohum Daftary · Rating 2 out of 5]

Very detailed, but difficult to get through. I think it gets lost down rabbit holes of different algos rather than staying high level and dropping down selectively. Definitely did not come away with a better understanding of trading / markets.

[Zhong Sheng · Rating 3 out of 5]

a book trying to achieve both comprehensive and depth, eventually it is a bit lack of both.

[Louis]

browsed quickly. Too academic. Interviews ok.

[Connor Colao · Rating 3 out of 5]

Pederson does a good job of balancing academic writing with practical explanations of different strategies. I didn't think the interviews were as interesting as they could have been.

[Guo Yang]

My introduction book to funds.