1. The Efficient Market Hypothesis
BM410 Investments
The Efficient Market Hypothesis or
Is there really a free lunch?

2. Objectives R. Review Portfolio Theory up to today
A. Understand the efficient market hypothesis and why securities prices should be essentially unpredictable
B. Be able to formulate investment strategies that make sense in informationally efficient markets.
C. Understand the tests of market efficiency and cite evidence that supports and contradicts the EMH
D. Understand some market anomalies to the EMH

3. Review of Financial Theory
What we have discussed
A two asset portfolio – with leverage
Modern Portfolio Theory
The development of the efficient frontier
The efficient frontier with CALs
CAPM, and its movement toward Beta
APT

4. Two Assets and the CAL s CAL: (Capital Allocation Line) E(r) P
Risk premium
E(rp) -
rf = 8%
) S = 8/22
rf = 7% F
Slope: Reward to variability ratio: ratio of risk premium to std. dev. s P
= 22%
This graph is the risk return combination available by choosing different values of y. Note we have E(r) and variance on the axis.

5. MPT: The Impact of Correlation
E(r)
r = 1
r = -1
r = .3
13% 8%
12%
20%
St. Dev
MPT: The Impact of Correlation
r = 0
TWO SECURITY PORTFOLIOS WITH DIFFERENT CORRELATIONS

6. The Efficient Frontier
Individual
assets
Global
minimum
variance
portfolio
Minimum
variance
frontier
The minimum-variance frontier of risky assets
St. Dev.

7. The Efficient Frontier with CALs
CAL (P)
CAL (A) M M P P
CAL (Global
minimum variance) A A G F s P
P&F M
A&F

8. CAPM and The Security Market Line
Notice that instead of using standard deviation, the SML uses Beta
SML Relationships
b = [COV(ri,rm)] / sm2
Slope SML = E(rm) – rf = market risk
premium
E(r)
SML
E(rM) rf
SML = rf + b[E(rm) - rf] ß ß
= 1.0 M

9. CAPM: Expected Return– Beta Relationship
E(rM) - rf = E(rs) - rf bs
In other words, the expected rate of return of an asset exceeds the risk-free rate by a risk premium equal to the asset’s systematic risk (its beta) times the risk premium of the market portfolio. This leads to the familiar:
E(rs) = rf + bs [E(rM) - rf ]

10. APT and the Security Characteristic Line
Excess Returns (i)
SCL . . .
Plot of a company’s excess return as a function of the excess return of the market . . . . . . . . . . . . . . . . . . . . . . . .
Excess returns
on market index . . . . . . . . . . . . . . . . . . . . . . .
Ri = a i + ßiRm + ei

11. A. Efficient Market Hypothesis and why Securities Prices should be Unpredictable
What is the Efficient Market Hypothesis (EMH)?
A hypothesis (or theory) that security prices reflect all available information, i.e., historical, public, and non-public
A framework for trying to understand the movements in stock prices
Probably the single most important paradigm in finance
Why is it important?
It helps us understand formulate a basis for various investment strategies and also explain why prices move the way they do

12. What is Market Efficiency?
What is efficiency?
The quality or degree of being efficient, effective operation as measured by a comparison of production/energy with cost/output
Are their different types of efficiency?
Operational efficiency
The measure of how well things function in terms of speed of execution and accuracy
Informational efficiency (i.e. market efficiency)
The measure of how quickly and accurately the market reacts to new information

13. Degrees of Informational Efficiency
Weak form
Stock prices reflect all information contained in the history of past trading—no benefit from past prices
Semi-strong form
Stock prices reflect all publicly available information — no benefit from 10Ks, 10Qs, etc.
Strong form
Stock prices reflect all relevant information, including past, public, and inside information– no benefit from any insider information SF
SSF
Weak Form

14. Random Walk and the EMH What is a Random Walk?
The notion that stock prices are random and unpredictable
Since information comes randomly, then its impact on stock prices should be random as well
Price changes are actually a sub martingale
The expected price is generally positive over time
It has a positive trend and is random about the trend

15. Random Walk with Positive Trend
Security
Prices
Time

16. Efficient Markets Hypothesis and Competition
Stock prices fully and accurately reflect publicly available information
Once information becomes available, market participants analyze it
Participants will buy and sell based on that new information
Competition assures prices reflect information, as securities will be bought and sold until the point that all new information is embedded in the price

17. Are there Other Theories?
Semi-efficient market hypothesis (among others)
A cousin of the EMH
States that some stocks are priced more efficiently than others
This is generally used to support the notion of tiering in the markets
Analysts can only follow so many stocks, so they follow the largest
The smaller are less followed, and hence are more likely to be less-efficiently priced

18. Questions
Any questions of the Efficient Market Hypothesis and why stock prices should be unpredictable?

19. Problem #1
Which of the following most appears to contradict the proposition that the stock market is weak-form efficient? Explain.
A. Over 25% of mutual funds outperforms the markets on average.
B. Insiders earn abnormal trading profits
C. Every January, the stock market earns above normal returns.

20. Answer #1
c. Predictable returns should not occur according to the weak-form efficient market hypothesis. Higher than average returns in the month of January each year contradicts the weak-form EMH.

21. Investment Strategies in Informationally Efficient Markets
Does your view of efficient markets have an impact on how you manage a portfolio?
Stock analysis assumes the markets are not weak and semi-strong form efficient
Technical Analysis - using prices and volume information to predict future prices
Violates weak-form efficiency
Fundamental Analysis - using economic and accounting information to predict stock prices
Violates semi-strong form efficiency

22. Implications of EMH Efficiency
Active Management
If markets are efficient, then it depends on the degree of efficiency
Security analysis assumes you can add even a little bit of value
It doesn’t have to be too much if you are managing a large fund
Timing assumes you can make decisions regarding the attractiveness of various asset classes

23. Implications of EMH Efficiency
Passive Management
This is useful and cheap
Buy and Hold
Since the EMH indicates prices are at a fair value, it makes no sense to buy, sell, or do any type of analysis
Index Funds
If you can’t beat them, join them – mimic a broad benchmark of securities, i.e. the S&P 500

24. Market Efficiency and Portfolio Management
What if the markets are efficient? Is there still a role for portfolio management?
Even if the markets are efficient, a role exists for portfolio management
Determining an appropriate risk level
Understanding tax considerations
Taking into account other individual investment considerations for a portfolio

25. Questions
Do you understand how the implications of the EMH will affect trading strategies?

26. Problem #2
Some scholars contend that professional managers are incapable of outperforming the market. Others come to an opposite conclusion. Compare and contrast the assumption about the stock market that support (a) passive portfolio management and (b) active portfolio management.

27. Answer #2
Assumptions that support passive management are that all available information is already reflected in the price of stocks. The fees for passive management are minimal.
Assumptions that support active management are that there are pockets of market inefficiency. Active management is more feasible for managers of large portfolios.

28. Understand Empirical Tests of Market Efficiency
How are tests made of the Efficient Market Hypothesis?
Most common are:
Performance Attribution: Assessing performance of professional managers
Testing of filter / trading rules
Event studies

29. Performance Attribution
Results from Mutual Fund and Professional Manager Performance
There is some evidence of persistent positive and negative performance
The problem is that it takes time to determine both
Sometimes positive returns are from managers investing outside their benchmark
Potential measurement error for benchmark returns
Style changes have occurred
May be risk premiums involved
There is a superstar phenomenon (Lynch, Buffett, etc.)

30. Testing of Filter/Trading Rules
Very limited support of trading rules
A trading rule might suggest you buy when the stock passes its 360 day moving average and sell when it drops below its 45 day moving average
Those who make money on trading rules are generally those selling the books
Once a trading rule is known, it is generally exploited and then the inefficiency is lost

31. Event Studies How Tests Are Structured
1. Examine prices and returns over time
Formulate a hypothesis (and choose an appropriate test statistic)
2. Adjust returns to determine if they are abnormal
Select a model, i.e. Rt = at + btRmt + et and compare expected returns to actual returns
3. Compare actual results with expected results
See how well your actual results were predicted by your model

32. Event Studies (continued)
Results of Event Studies:
If the results are good, you invest money with the test—you do not let anyone know, but make lots of money and retire early
If the results are bad, you publish the results and make tenure, or try to sell books and tapes via the radio and TV to unsuspecting buyers who don’t know any better

33. Event Studies (continued)+t
Announcement Date
Returns Surrounding the Event

34. Final Thoughts on Market Efficiency
Key Issues:
Magnitude Issue
A 1 basis point improvement for a $100K portfolio is much less important than for a $10bn portfolio
Size matters
Selection Bias Issue
Investment schemes that don’t work are published, and those that do are used to make money
We only hear of those that don’t work

35. Market Efficiency (continued)
Lucky Event Issue
It is more difficult to prove skill than luck
It takes more time to prove skill
Possible Model Misspecification
Perhaps the market is efficient but the model is incorrectly stated
We may be using the wrong model

36. Market Efficiency (continued)
What Does the Evidence Show?
If it sounds too good to be true, it usually is
It must make good common business sense
Common sense is all too uncommon
Technical Analysis
May be helpful for certain events
But generally has not shown excess returns for a longer period of time

37. Market Efficiency (continued)
Fundamental Analysis
Has been shown to add value
But analysts must forecast firms earnings better than everyone else
Anomalies Exist
But invest in them at your peril
An anomaly discussed means it is known
It is less like to do the same next time because others will be watching for it as well.

38. Understand Anomalies to the EMH
What is a market anomaly?
A market anomaly refers to price behavior that differs from the behavior predicted by the efficient market hypothesis.
An anomaly discussed means it is known
It is less like to do the same next time because others will be watching for it as well.
Are their anomalies that are known?

39. Anomalies (continued)
Price Earnings Effect
Portfolio’s of low P/E stocks have exhibited higher average risk-adjusted returns than higher P/E Stocks
Investors prefer cheaper stocks even if risk levels are the same.
Small Firm Effect
Smaller firms generally earn higher returns
May be tied to fact that ownership of smaller firms is left to smaller investors who require a higher return to invest.

40. Anomalies (continued)
January Effect
Stocks tend to exhibit a higher return in January than any other month (higher for smaller stocks)
May be tied to tax-loss selling or window dressing at year-end
Neglected Firm Effect
Firms not followed by analysts tend to perform better than those followed
Because costs are higher to analyze smaller firms, investors require a higher rate of return to invest in less liquid stocks

41. Anomalies (continued)
Liquidity Effect
Less liquid stocks sometimes perform better than more liquid stocks
Investors may require a higher return premium to compensate for lower liquidity
Market to Book Ratios
Stocks with lower price to book ratios (or higher book to market ratios) perform better
Investors prefer to invest in cheaper stocks (in reference to their assets)

42. Anomalies (continued)
Reversals
Extreme stock market performance tends to reverse itself, i.e. reversion to the mean.
Losers rebound and winners fall
Value Line Enigma
Stocks rated highly by Value Line perform better
Investors may read Value Line

43. Anomalies (continued)
Post-Earnings Announcement Drift
The effect of earnings announcements continue for many days after the announcement
May be due to trading costs, particularly for smaller companies

44. Problem #3 What is a market anomaly? A market anomaly refers to:
A. An exogenous shock to the market that is sharp but not persistent.
B. A price or volume even that is inconsistent with historical price or volume trends.
C. A trading or pricing structure that interferes with efficient buying and selling of securities.
D. Price behavior that differs from the behavior predicted by the efficient markets hypothesis.

45. Answer #3
d). A market anomaly refers to price behavior that differs from the behavior predicted by the efficient market hypothesis.

46. Questions
Do you understand the tests of market efficiency and can you cite evidence that supports or contradicts the EMH?

47. Problem #4
Prices of stocks before stock splits show on average consistently positive abnormal returns. Is this a violation of the EMH?

48. Answer #4 No this is not a violation of the EMH.
Usually stock splits occur as a response to good performance which drives up the stock price and leads managers to split the stock.
When the managers announce a stock split the good performance of the stock is already accounted for in the price of the stock.

49. Final Thoughts on Securities Analysis
Securities Analysis is like a horse show
But its not determining which is the best horse
But which horse will the judges consider the best horse!
You have to decide!!!!!!!

50. Review of Objectives
A. Do you understand the efficient market hypothesis and why securities prices should be essentially unpredictable?
B. Can you formulate investment strategies that make sense in informationally efficient markets?
C. Do you understand the tests of market efficiency and cite evidence that supports or contradicts the EMH?
D. Do you understand anomalies that exist to the EMH?