Equity Investments I
Reading 38. Market Efficiency
Learning Outcome Statements
d. contrast weak-form, semi-strong-form, and strong-form market efficiency;
e. explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management;
CFA Curriculum, 2020, Volume 5
Subject 2. Forms of Market Efficiency
- The weak-form hypothesis asserts that stock prices already reflect all the information that can be derived by examining market trading data, such as the history of past prices, trading volume, or short interest. This implies that trend analysis is fruitless: if such data ever conveyed reliable signals about future performance, all investors would have become familiar with such signals already.
- The semi-strong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. Such information includes (in addition to past prices) fundamental data on the firm's product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. Obviously this version encompasses the weak-form EMH. This hypothesis implies that an investor cannot achieve risk-adjusted excess returns using important public information.
- The strong-form hypothesis states that stock prices reflect all information (from public and private sources) relevant to the firm, including information available only to company insiders. This version of EMH encompasses both the weak-form and the semi-strong-form EMH. It is quite extreme. It implies that no investor has monopolistic access to information that influences prices. Thus, no investor can consistently derive risk-adjusted excess returns. In fact, the strong-form EMH assumes perfect markets, in which all information is cost-free and available to everyone at the same time. In contrast, in an efficient market prices adjust rapidly to new public information.
Implications of EMHs
The assumptions of technical analysis directly oppose the notion of efficient markets.
- The process of disseminating new information takes time.
- Stock prices move to new equilibriums in a gradual manner.
- Hence, stock prices move in trends that persist.
Therefore, technical analysts believe that good traders can detect the significant stock price changes before others do. However, as confirmed by most studies, the capital market is weak-form efficient as prices fully reflect all market information as soon as the information becomes public. Though prices may not be adjusted perfectly in an efficient market, it is unpredictable whether the market will over-adjust or under-adjust at any time. Therefore, technical analysts should not generate abnormal returns and no technical trading system should have any value.
Fundamental analysts believe that:
- At any time, there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities;
- These values depend on underlying economic factors such as cash flows and risk variables;
- Though market price and the intrinsic value may differ over time, the discrepancy will get corrected as new information arrives.
Therefore, by accurately estimating the intrinsic value, a fundamental analyst can achieve abnormal returns by making superior market timing decisions or acquiring undervalued securities.
Fundamental analysis involves aggregate market analysis, industry analysis, company analysis, and portfolio management. However, using historical data to estimate the relevant variables is as much an art and a product of hard work as it is a science. A fundamental analyst must do a superior job to predict earnings surprises to beat the market.
- Market analysis. Analysis relying solely on historical data will not yield superior, risk-adjusted returns as the EMH asserts that the market adjusts rapidly to public information. The analyst must be good at estimating the relevant variables that cause long-run trends of market movements.
- Industry and company analysis. The EMH implies that to achieve abnormal returns, an analyst must correctly estimate future values for variables that influence rates of return and predict future earnings surprises. The estimates must differ from the consensus. There will be no superior return if the analyst predicts the consensus and the consensus is correct. Therefore, the analyst should pay more attention to areas where the market is inefficient, such as stocks that are neglected by other analysts, stocks with high book value/market value ratios, and stocks with small market capitalization.
Since the capital markets are primarily efficient, the majority of portfolio managers cannot beat a buy-and-hold policy on a risk-adjusted basis. However, on many occasions the market fails to adjust prices rapidly in response to public information, and superior investment performance is likely to be achieved through active security valuation and portfolio management. This achievement relies on superior analysts who can time major market trends or identify undervalued securities. Hence, the decision of how one manages a portfolio (actively or passively) should depend on whether the manager has access to superior analysts.
If a portfolio manager has access to superior analysts, he or she can manage a portfolio actively, looking for undervalued securities based upon superior fundamental analysis (including predicting earnings surprises) and attempting to time the market when asset allocation is shifted between aggressive and defensive positions. The portfolio manager should ensure that the risk preferences of the client are maintained.
If a portfolio manager does not have access to superior analysts, he or she should:
- Determine and quantify his risk preferences;
- Construct the appropriate risk-level portfolio by dividing the total portfolio between lending or borrowing risk-free assets and a portfolio of risky assets;
- Diversify completely on a global basis to eliminate all unsystematic risk;
- Maintain the specific risk level by rebalancing when necessary;
- Minimize taxes and total transaction costs (reduce trading turnover and trade relatively liquid stocks to minimize liquidity costs).
The Rationale of Index Funds
If companies don't have superior analysts who can beat the market, then the analysts should simply attempt to match the market at the lowest cost. To achieve a market rate of return, diversification in numerous amounts of stocks is required, which may not be an option for a smaller investor. Index funds (also referred to as market funds) are security portfolios designed to duplicate the composition and therefore the performance of a selected market index series.