The Efficient Markets Hypothesis

Dr. Kumail Rizvi, CFA, FRM

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
How Participants incorporate
Information
OGDCL: Profit increase by 52%, sales increase
by 27%, everything looks very nice and good.
EPS is 22.57 ps, Dividend is 7.8 ps
P/E has been reduced from 10.x to 7.5 this year.
Industry P/E average is 14.0x
Why market participants are not willing to pay
for each rupee of earning ACCORDINGLY
Major cut in Exploration cost, Circuler debt issue
is also there: 120 billion rupees are stuck, almost
half of total current assets and third of total
assets

The Weak Form
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 Adjustment with New Information
At 10AM EST, the U.S. Supreme Court refused to hear an appeal
from MSFT regarding its anti-trust case. The stock immediately
dropped. This example, one of hundreds available every day,
illustrates that prices adjust extremely rapidly to new information.
But, did the price adjust correctly? Only time will tell, but it does
seem that over the next hour the market is searching for the correct
level.
Notes: Each bar represents high, low, and close for one-minute. Each solid gridline represents the top of an hour, and each
dotted gridline represents a half-hour.
Tests of the Weak Form
Serial correlations.
Runs tests.
Filter rules.
Relative strength tests.
Many studies have been done, and nearly all
support weak form efficiency, though there have
been a few anomalous results.
Serial Correlations
The following chart shows the relationship (there is
none) between S&P 500 returns each month and the
returns from the previous month. Data are from Feb.
1950 to Sept. 2001.
Note that the R
2
is virtually 0 which means that knowing
last months return does you no good in predicting this
months return.
Also, notice that the trend line is virtually flat (slope =
0.008207, t-statistic = 0.2029, not even close to
significant)
The correlation coefficient for this data set is 0.82%
Serial Correlations (cont.)
Unlagged vs One-month Lagged S&P 500
Returns
y = 0.008207x + 0.007451
R
2
= 0.000067
-30.00%
-20.00%
-10.00%
0.00%
10.00%
20.00%
-30.00% -20.00% -10.00% 0.00% 10.00% 20.00%
One-month Lagged Returns
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The Semi-strong Form
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.
Tests of the Semi-strong Form
Event Studies
Stock splits
Earnings announcements
Analysts recommendations
Cross-Sectional Return Prediction
Firm size
BV/MV
P/E
Analysts Performance
This chart from the Wall Street Journal, shows that when analysts issue
sell recommendations, those stocks frequently outperform those with
buy or hold ratings. If the professionals cant get it right, who can?
Mutual Fund 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 Strong Form
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 Strong Form
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 Size 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 Incredible January 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 Week 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.
Summary 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.