The Efficient Markets

Hypothesis
Mohammad Ali Saeed
Active or Passive
Management?

Investors, as a group, can do no better than the market,

because collectively they are the market. Most investors
trail the market because they are burdened by
commissions and fund expenses. Jonathan Clements, the
Wall Street Journal,
June 17, 1997

Fees paid for active management are not a good deal for
investors, and they are beginning to realize it. Michael
Kostoff, executive director, The Advisory Board, a Washington-
based market research firm. InvestmentNews, February 8, 1999

When you layer on big fees and high turnover, youre

really starting in a deep hole, one that most managers cant
dig their way out of. Costs really do matter. George
Gus Sauter, Manager of the Vanguard S&P 500 Index Fund
Active or Passive
Management?
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Definition of Efficient
Markets

An efficient capital market is a market that is efficient

in processing information.

We are talking about an informationally efficient

market, as opposed to a transactionally efficient
market. In other words, we mean that the market
quickly and correctly adjusts to new information.

In an informationally efficient market, the prices of

securities observed at any time are based on
correct evaluation of all information available at that
time.

Therefore, in an efficient market, prices immediately

and fully reflect available information.
Definition of Efficient
Markets (cont.)

Professor Eugene Fama, who coined the

phrase efficient markets, defined market
efficiency as follows:

"In an efficient market, competition among the

many intelligent participants leads to a situation
where, at any point in time, actual prices of
individual securities already reflect the effects of
information based both on events that have
already occurred and on events which, as of now,
the market expects to take place in the future. In
other words, in an efficient market at any point in
time the actual price of a security will be a good
estimate of its intrinsic value."
History

Prior to the 1950s it was generally believed that the

use of fundamental or technical approaches could
beat the market (though technical analysis has
always been seen as something akin to voodoo).

In the 1950s and 1960s studies began to provide

evidence against this view.

In particular, researchers found that stock price

changes (not prices themselves) followed a random
walk.

They also found that stock prices reacted to new

information almost instantly, not gradually as had
been believed.
The Efficient Markets
Hypothesis

The Efficient Markets Hypothesis (EMH)

is made up of three progressively
stronger forms:

Weak Form

Semi-strong Form

Strong Form
The EMH Graphically

In this diagram, the

circles represent the
amount of information
that each form of the
EMH includes.

Note that the weak form

covers the least amount
of information, and the
strong form covers all
information.

Also note that each

successive form
includes the previous
ones.
Strong Form
Semi-Strong
Weak Form
All information, public and private
All public information
All historical prices and returns
The eak !orm

The weak form of the EMH says that past prices, volume, and
other market statistics provide no information that can be used
to predict future prices.

If stock price changes are random, then past prices cannot be

used to forecast future prices.

Price changes should be random because it is information that

drives these changes, and information arrives randomly.

Prices should change very quickly and to the correct level when
new information arrives (see next slide).

This form of the EMH, if correct, repudiates technical analysis.

Most research supports the notion that the markets are weak
form efficient.
Price A"#$stment %ith &e%
'nformation
At 10AM EST, the U.S. Supreme ourt refused to hear a! appeal
from MS"T re#ardi!# its a!ti$trust case. The stoc% immediatel&
dropped. This e'ample, o!e of hu!dreds a(ailable e(er& da&,
illustrates that prices ad)ust e'tremel& rapidl& to !e* i!formatio!.
+ut, did the price ad)ust correctl&, -!l& time *ill tell, but it does
seem that o(er the !e't hour the mar%et is searchi!# for the correct
le(el.
Notes. Each bar represe!ts hi#h, lo*, a!d close for o!e$mi!ute. Each solid #ridli!e represe!ts the top of a! hour, a!d each
dotted #ridli!e represe!ts a half$hour.
The (emi)strong !orm

The semi-strong form says that prices fully

reflect all publicly available information and
expectations about the future.

This suggests that prices adjust very rapidly

to new information, and that old information
cannot be used to earn superior returns.

The semi-strong form, if correct, repudiates

fundamental analysis.

Most studies find that the markets are

reasonably efficient in this sense, but the
evidence is somewhat mixed.
Analysts Performance
This chart from the /all Street 0our!al, sho*s that *he! a!al&sts issue
sell recomme!datio!s, those stoc%s fre1ue!tl& outperform those *ith
bu& or hold rati!#s. 2f the professio!als ca!3t #et it ri#ht, *ho ca!,
M$t$al !$n" Performance

Generally, most academic studies have found that

mutual funds do not consistently outperform their
benchmarks, especially after adjusting for risk and
fees.

Even choosing only past best performing funds (say,

5-star funds by Morningstar) is of little help. A study
by Blake and Morey finds that 5-star funds dont
significantly outperform 3- and 4-star funds over time.

However, it does seem that you can weed out the

bad funds (1- and 2-stars). Funds that have
performed badly in the past seem to continually
perform badly in the future.
The (trong !orm

The strong form says that prices fully

reflect all information, whether publicly
available or not.

Even the knowledge of material, non-

public information cannot be used to
earn superior results.

Most studies have found that the

markets are not efficient in this sense.
Tests of the (trong !orm

Corporate Insiders.

Specialists.

Mutual Funds.

Studies have shown that insiders and

specialists often earn excessive profits, but
mutual funds (and other professionally
managed funds) do not.

In fact, in most years, around 85% of all

mutual funds underperform the market.
Anomalies

Anomalies are unexplained empirical

results that contradict the EMH:

The Size effect.

The Incredible January Effect.

P/E Effect.

Day of the Week (Monday Effect).

The (i*e Effect

Beginning in the early 1980s a number of

studies found that the stocks of small firms
typically outperform (on a risk-adjusted basis)
the stocks of large firms.

This is even true among the large-

capitalization stocks within the S&P 500. The
smaller (but still large) stocks tend to
outperform the really large ones.
The 'ncre"i+le ,an$ary
Effect

Stock returns appear to be higher in

January than in other months of the
year.

This may be related to the size effect

since it is mostly small firms that
outperform in January.

It may also be related to end of year tax

selling.
The P-E Effect

It has been found that portfolios of low P/E

stocks generally outperform portfolios of high
P/E stocks.

This may be related to the size effect since

there is a high correlation between the stock
price and the P/E.

It may be that buying low P/E stocks is

essentially the same as buying small
company stocks.
The Day of the eek
Effect

Based on daily stock prices from 1963 to 1985 Keim

found that returns are higher on Fridays and lower on
Mondays than should be expected.

This is partly due to the fact that Monday returns

actually reflect the entire Friday close to Monday
close time period (weekend plus Monday), rather
than just one day.

Moreover, after the stock market crash in 1987, this

effect disappeared completely and Monday became
the best performing day of the week between 1989
and 1998.
($mmary of Tests of the
EMH

Weak form is supported, so technical analysis cannot

consistently outperform the market.

Semi-strong form is mostly supported , so

fundamental analysis cannot consistently outperform
the market.

Strong form is generally not supported. If you have

secret (insider) information, you CAN use it to earn
excess returns on a consistent basis.

Ultimately, most believe that the market is very

efficient, though not perfectly efficient. It is unlikely
that any system of analysis could consistently and
significantly beat the market (adjusted for costs and
risk) over the long run.