"The difference between theory and practice is that in theory, there is no difference between theory and practice; but in practice, there always is." - A quote usually attributed to Yogi Berra but actually now traced to computer scientist Jan LA van de Snepscheut.
The standard joke about economists propounding the theory of efficient markets is the one about two of them walking down a windy Chicago street and spotting a $100 bill on the sidewalk. As one reaches down to pick up the bill, the other economist cautions him "Don't be silly - it cannot be a $100 bill because someone ELSE would have picked it up already."
Eugene Fama's work on the efficient-market hypothesis (EMH), which asserts that financial markets are "informationally efficient", has garnered him a Nobel Economics Prize for an insight no
greater than suggesting that "active" investment strategies, ie stock picking to the average man on the street, cannot produce efficient returns relative to the broader market or "index based" simply due to two factors:
Transaction costs - that is, that buying an index is cheaper than actively buying and selling stocks; and
Agency failures - that is, the likely human failure of active investors to pick up the next Apple or spot the impending collapse of an Enron any more than the market.
Over the past 20 years, this theory has led to the widespread use of index-linked funds to the detriment of actively managed vehicles. Typically, index-linked funds do nothing more than buy all the stocks in an index in the exact weights of the index and then adjust the weights as the index moves. This creates a proxy of the broader market, with less (smaller) transaction costs.
Competing against these funds would be the actively managed equity funds, where fund managers would have to buy and sell their favorite and least favorite stocks: the idea being to make more money on the stocks that are picked as going up and losing less on the stocks that are going down.
Hedge funds that focus on stock markets have more flexibility in this regard as they can both buy high concentrations of stocks and also go short specific stocks or sectors (for example, airlines or financials) as against mutual funds. The strategies are referred to as long-short and long-only.
Despite the advantages of hiring a lot of people with fancy MBAs and CFAs, it is a fact of life that active long-only mutual funds and their long-short hedge fund counterparts both produce net returns that pale in comparison to the broader market.
To be sure, there are exceptions to these rules. The most quoted is Warren Buffett, whose Berkshire Hathaway has steadily outperformed the S&P500 over the past few decades. However, I am amongst those who believe that the comparison isn't apt because Mr Buffett, for all his supposed talents, is not an index tracker nor does he have any liquidity requirements that can only be fulfilled by selling stocks.
Instead, his strategy has been more private-equity like: buying large stakes in publicly listed companies (Coca Cola, McDonald's) or taking private a number of strategically positioned companies (Burlington Santa Fe, Heinz). Neither of these strategies is available to the broader market, nor to active fund managers; therefore to compare the performance of Berkshire to these benchmarks would violate basic rules of statistics.
The second major exceptions are certain hedge funds that have consistently outperformed the broader market, even after deducting their gargantuan fees. Within this are two sub-categories namely the "how did they do it" guys and the "Black Swan" guys. 
The mystery of the "how did they do it" guys has unfortunately been revealed in recent months - the likes of Galleon and now SAC Cohen have been felled by insider trading revelations (or allegations); denting the aura of superior analytics and deep research which were previously attributed as the key reasons for the outperformance.
"Black Swan" guys are the hedge fund mavens such as John Paulson and Kyle Bass who have made fortunes focusing their energies on asset bubbles that are bursting, such as the 2007 mortgage-backed crisis or the 2009 European sovereign debt crisis. These managers tend to focus on situations where the broader market simply ignores the mispricing of optionality: in other words, where observed volatility is far lower than future implied volatility (or future assessed volatility). Put simply, the catastrophe-porn guys simply make money by betting on other people's mistakes.
The problem with that second sub-category is that there aren't (or at least there haven't been) too many catastrophes in the broader market; therefore, you'd make a bit of money from time to time, but on average you'd be better off in the broader market. Sure enough, the reported returns on John Paulson's main funds have been mediocre since 2009, with huge losses reported from time to time, to boot.
What's the future
So can we conclude that the broader market is the best indicator of investor returns and therefore everyone should stick to index based funds?
Before doing so, let's look at the way US Treasury yields moved in relation to the government shutdown and the possibility of a default, however technical that might have been. There was actually nothing by way of panic in the US Treasury markets except in the very short end where fears of payment stoppages (or forced rollovers) on maturing Treasury bills pushed various money market funds to sell their positions, thereby causing a temporary spike in short-term yields against long-term bonds.
This also pushed up the London Interbank Offered Rate (LIBOR) as banks had less "good" collateral to post. Sure enough, the market's view has been validated by reports of an impending solution between the two major US political parties that would help avoid a default. So far, so good.
The point, though, is for investors to think about the last month in the US Treasury markets more dispassionately. What if the brinkmanship between the arms of government had (or better yet, still does) lead to a default? The ramifications would be terrifying, and would have destroyed capital worth hundreds of billions if not trillions in the equity and bond markets in a jiffy. You're talking 1,000 points off the Dow Jones / Nikkei in a day, going for a few days.
Meanwhile, US bond markets would have shut down and the short end would have seen yield hikes that would have frozen the money markets, in turn pushing most banks (still over-leveraged thanks to all the quantitative easing of the central banks) into insolvency.
Put simply, optionality was mispriced in the US Treasury market for the past two weeks, by a large amount. Despite all the headlines, there were more investors selling volatility than there were buying volatility; that's the reason for the relative calm in the markets. A "rational" investor would have balanced his long position in the markets - equity or bond - by buying some volatility viz. Puts on the bond or stock markets; but instead was seen SELLING puts on the same markets in order to eke out some income from (option) premiums.
Why? Folk selling volatility were doing so not so much because they trusted the politicians but because they needed the extra yields (thanks to QE, actual yields on assets being far too low to justify the market's overall risk): this is precisely what makes the herd a dangerous place to be from time to time. The assumption that investors and the broader market are rational has therefore been tested in the past month, with terrifyingly poor results for the rational markets hypothesis.
Given the widespread central bank intervention that has skewed asset prices globally, now is certainly not the time for anyone to depend on EMH; indeed the most plausible theory is to allocate between 65 to 80% of one's funds to index trackers and the rest to "Black Swan" managers whose job is to spot such opportunities.
1. "Black Swan" is named after the seminal book of the same name by Nicholas Nassim Taleb; the book details the failures of markets to spot and act on extreme risks.
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