There are no free lunches

Free lunch was a tradition once common in Saloons in United States.

Free lunch was a tradition once common in saloons in the US. It was a sales enticement that offered a meal at no cost in order to attract customers and build patronage. So popular was the scheme that a complete meal was offered with a 15 cents drink and people used to throng to such saloons, a few of them even complaining about the quality of food. On the other hand, it was Milton Friedman who popularised the term 'No free lunch' with his book. The term meant that in reality, a person or a society cannot get "something for nothing". In mathematical finance, this was an informal synonym for the no-arbitrage principle.

No free lunch in the capital market context can also mean inability to beat the benchmark. The 1968 study by Michael Jensen studied performance over the period of 1945-64. Essentially, Jensen found that all mutual fund alphas were indistinguishable from zero. Although there have been different studies done on the hot hand effect, beating the market has been known to be an unassailable feat. If a system could beat the market, the gains market participants could not just arbitrage away, the cost of generating such a system are low, the profits sizeable to take out transaction costs, then that system would be a new free-lunch opportunity.

But let’s first talk about the market first. Could Indexing DOW Jones as early as 1884 offer a kind of free lunch to market participants? After all, the Index offered an opportunity of a new perspective. It offered a diversified lower risk approach, compared to individually holding the components and there was a perceived value. Although it took more than 100 years for index futures to be traded on the index or exchange-traded fund (ETF), allowing investing opportunities based on the index, the fact that the system persisted till now is a proof of longevity, sustainability, visibility, and economic sense. This is a clear proof of an opportunity for low-cost participation in the market, which is harder to beat by mutual funds at a comparative risk level. The businesses built around indexing and the smart money-tracking innovation also confirm this. Today, more than a trillion dollar tracks passive indices like Dow globally. What started as a simple financial innovation spawned a new market.

Did the free lunch innovation stop? There is definitely a scarcity when it comes to free lunch financial innovations. A few reasons: First, there are few information gaps. Information drove the financial innovation business. Now with fewer information gaps, building financial innovations based on information is harder. Second, perception. We have had enough financial innovation and we have reached a peak for financial knowledge. Hence we can’t have any more financial innovations. Third, market mood. The active financial innovations are blamed for the crisis. Hence, there are fewer consumers for new financial innovations.

What could be a new free lunch financial innovation? Today, if a system could marry momentum with reversion styles of investing (trending and contrarian styles), combine various research approaches (fundamental, technical, statistical, etc), work across natural systems (within or outside capital markets), and beat the available benchmarks on a comparable risk footing, this could spawn a new industry. Research Affiliates filed a patent on their fundamental indexing methodology beating the S&P 500 by 2 per cent and emerging market by 2.5 per cent annually in 2004. About $140 billion worth of money tracks fundamental index.

Orpheus recently filed a patent for another such market-beating system working as a natural system across asset classes and across regions beating the S&P 100 by more than five per cent annually. There are a handful of well known companies that have done innovative work in the area of market indexing such as S&P DJ Indices and Russell’s. These indexing approaches are nothing short of new free lunch innovations.

The author is CMT, and Founder, Orpheus CAPITALS, a global alternative research firm