No Free Lunch

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 popularized 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 sizable 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.

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Mukul Pal, is a Chartered Market Technician, MBA Finance and a member of the reputed Market Technicians Association (MTA). He has more than a decade of Capital Market experience dealing with derivatives and global assets. He has worked for Bombay Stock  Exchange, multinational Banks and brokerage houses in leading research positions before starting on his own in 2005. He is the President of the MTA Central and Eastern European Chapter.


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