1. Alpha, the Capital Markets, and the Efficient Markets Hypothesis (Chapter 6)
Adapted from Portfolio Construction, Management, & Protection, 4e, Robert A. Strong
Copyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

2. No matter how many winners you’ve got, if you either leverage too much or do anything that gives you the chance of having a zero in there, it’ll all turn into pumpkins and mice.
Warren Buffett

3. Outline Introduction Alpha and Portfolio Management
Role of the Capital Markets
Efficient Market Hypothesis
Anomalies

4. What is “alpha”?
Alpha = the amount by which the market is beaten, after adjusting for risk
What is alpha for the market as a whole?
Alpha for market as a whole is zero
So, on average, portfolios are ON the SML
Provides conceptual value of CAPM
Regardless of whether market is efficient, it is still a zero-sum game
Burden of active manager
In order to win (i.e., beat the market), someone else has to lose
Key question = what is special about you (and about your knowledge) that will allow you to be the one that wins?

5. Generating alpha Are there ways to consistently generate alpha?
See portfolio manager performance example:

6. Portfolio Manager’s Performance: Past Three Years
Previous Three Years:
S&P 500
Fund Manager
Compound Annual Return
-4.98%
-22.01%
Total Return
-14.20%
-52.56%

7. Portfolio Manager’s Performance: Past Four Years
Previous Four Years:
S&P 500
Fund Manager
Compound Annual Return
0.50%
-14.19%
Total Return
2.02%
-45.77%

8. Portfolio Manager’s Performance: Past Five Years
Previous Five Years:
S&P 500
Fund Manager
Compound Annual Return
3.17%
-0.54%
Total Return
16.91%
-2.67%

9. Portfolio Manager’s Performance: Past Six Years
Previous Six Years:
S&P 500
Fund Manager
No. of Down Years
2 of 6
4 of 6
Compound Annual Return
3.29%
-1.66%
Total Return
21.47%
-9.58%

10. Generating alpha Would you have invested with this manager?
Who is this manager with this horrible record?
Warren Buffett, of course!!!
Portfolio = investment in Berkshire-Hathaway, over the period of 1970 – 1975
Note: while stock price lagged market substantially, book value per share grew faster than market each year except 1975; this is a metric with which Buffett is more concerned

11. Generating alpha
As we have seen previously in discussing the EMH, value stocks tend to outperform growth stocks
Concomitantly, Warren Buffett has the best investment record in history, becoming the 2nd richest man in the world in the process
However, as we have just now seen, although value wins on average, over the long run, it does not win perfectly consistently!
Instead, the markets tend to cycle, with different styles of investment performing well at different times

12. Book to Market as a Predictor of Return: Value (positive a) tends to outperform Growth (negative a)0% 5%
10%
15%
20%
25%
Annualized Rate of Return
Value
Growth 10 9 8 7 6 5 4 3 2 1
High Book/Market Low Book/Market

13. Rolling Annualized Average 5-year Difference
Between the Returns to Value and Growth Composites:
The Market cycles between Value and Growth,
But Value Wins on Average
50%
40%
30%
20%
Relative Difference
10% 0%
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
-10%
-20%
Year

14. Empirical Regularities: Sources of alpha
Three categories that tend to outperform over the long run:
Value stocks vs. Growth stocks
Size: Small caps tend to outperform large caps
Momentum: stocks with momentum (earnings or price) tend to beat stocks without momentum
However, the payoffs to all of these tend to cycle!
A typical portfolio manager, being judged on a quarter-by-quarter basis, would have been fired long before if he had the same record as Buffett for 1970 – 1975!
(In fact, he fired himself during this period!)
None of these beats the market perfectly consistently
A typical portfolio manager would need to try to cycle along with the market, in order to keep from ever lagging too far behind it

15. Empirical Regularities: Sources of alpha
Beating the market consistently would require some sort of rotation strategy in order to profit from the type of securities that are performing well in the given type of market
But - combination of “fat tails” and “volatility clustering” (discussed previously) can cause problems!
Best performance for a given style is likely to follow closely on the heels of its worst performance, and much of the movement for the style is likely to come in a relatively short burst (thus, if you miss it, it’s gone)
E.g.: 40% of the stock market gains for the entire decade of the 1980’s occurred during a mere 10 trading days !
So efforts to cycle with the market and keep from falling too far behind it also make it much more difficult to beat the market!

16. Capital Market Theory
Capital market theory springs from the notion that:
People like return
People do not like risk
Dispersion around expected return is a reasonable measure of risk

17. Role of the Capital Markets
Definition
Economic Function
Continuous Pricing Function
Fair Price Function

18. Definition
Capital markets trade securities with lives of more than one year
Examples of capital markets
New York Stock Exchange (NYSE)
American Stock Exchange (AMEX)
Chicago Board of Trade
Chicago Board Options Exchange (CBOE)

19. Economic Function
The economic function of capital markets facilitates the transfer of money from savers to borrowers
e.g., mortgages, Treasury bonds, corporate stocks and bonds

20. Continuous Pricing Function
The continuous pricing function of capital markets means prices are available moment by moment
Continuous prices are an advantage to investors
Investors are less confident in their ability to get a quick quotation for securities that do not trade often

21. Fair Price Function
The fair price function of capital markets means that an investor can trust the financial system
The function removes the fear of buying or selling at an unreasonable price
The more participants and the more formal the marketplace, the greater the likelihood that the buyer is getting a fair price

22. Efficient Market Hypothesis
Definition
Types of Efficiency
Forms of Efficiency
Weak Form
Semi-Strong Form
Strong Form
Semi-Efficient Market Hypothesis
Security Prices and Random Walks

23. Definition
The efficient market hypothesis (EMH) is the theory supporting the notion that market prices are in fact fair
Under the EMH, security prices fully and fairly (i.e., without bias) reflect all available information about the security
Since the 1960’s, the EMH has been perhaps the most important paradigm in finance
Whether markets are efficient has been extensively researched and remains controversial

24. Types of Efficiency
Operational efficiency measures how well things function in terms of speed of execution and accuracy
It is a function of the number of orders that are lost or filled incorrectly
It is a function of the elapsed time between the receipt of an order and its execution

25. Types of Efficiency (cont’d)
Informational efficiency is a measure of how quickly and accurately the market reacts to new information
This is the type of efficiency with which the EMH is concerned
The market is informationally very efficient
Security prices adjust rapidly and fairly accurately to new information
However, as we’ve already seen, the market is still not completely efficient

26. Forms of Market Efficiency
Eugene Fama’s original formulation of the Efficient Market Hypothesis established three forms of market efficiency, based on the level of information reflected in security prices:
Weak form = prices reflect all past market level (price and volume) information
Semi-strong form = prices also reflect all publicly available fundamental company and economic information
Strong form = prices also reflect all privately held information that would affect the value of the company and its securities

27. Weak Form
Definition
Charting
Runs Test

28. Definition
The weak form of the EMH states that it is impossible to predict future stock prices by analyzing prices from the past
The current price is a fair one that considers any information contained in the past price data
Charting techniques are of no use in predicting stock prices

29. Definition (cont’d) Example Which stock is a better buy? Stock A
Current Stock Price
Stock B

30. Definition (cont’d) Example (cont’d)
Solution: According to the weak form of the EMH, neither stock is a better buy, since the current price already reflects all past information.

31. Charting People who study charts are technical analysts or chartists
Chartists look for patterns in a sequence of stock prices
Many chartists have a behavioral element

32. Runs Test
A runs test is a nonparametric statistical technique to test the likelihood that a series of price movements occurred by chance
A run is an uninterrupted sequence of the same observation
A runs test calculates the number of ways an observed number of runs could occur given the relative number of different observations and the probability of this number
These tests have provided evidence in favor of weak form efficiency

33. Conducting A Runs Test

34. Semi-Strong Form
The semi-strong form of the EMH states that security prices fully reflect all publicly available information
e.g., past stock prices, economic reports, brokerage firm recommendations, investment advisory letters, etc.

35. Semi-Strong Form (cont’d)
Academic research supports the semi-strong form of the EMH by investigating various corporate announcements, such as:
Stock splits
Cash dividends
Stock dividends
Examined through “event studies”
This means investors are seldom going to beat the market by analyzing public news

36. Semi-Strong Form (cont’d)
Market seems to do a relatively good job at adjusting a stock’s valuation for certain types of new information
Determining how much the new info. will change the stock’s value and then adjusting the price by an equivalent amount
This is what event studies examine
But it does seem to have problems developing an overall valuation for a stock in the first place
E.g., What is the correct value for IBM as a whole is a very difficult question to answer, but how much IBM’s value should change if it is awarded a specific new contract is much easier to determine

37. Semi-Strong Form (cont’d)
Burton Malkiel points out that two-thirds of professionally managed portfolios are consistently beaten by a low-cost index fund
Suggests that securities are accurately priced and that in the long run returns will be consistent with the level of systematic risk taken
Supports semi-strong form of the EMH
Also would suggest that portfolio managers do not possess any private information that is not already reflected in security prices
Supports the strong form of the EMH

38. Strong Form
The strong form of the EMH states that security prices fully reflect all relevant public and private information
This would mean even corporate insiders cannot make abnormal profits by using inside information about their company
Inside information is information not available to the general public

39. Semi-Efficient Market Hypothesis
The semi-efficient market hypothesis (SEMH) states that the market prices some stocks more efficiently than others
Less well-known companies are less efficiently priced
The market may be tiered
A security pecking order may exist
Lynch prefers stocks that “the analysts don’t follow … and the institutions don’t own …”
See the Small Firm and Neglected Firm Effects discussed later

40. Security Prices and Random Walks
The unexpected portion of news follows a random walk
News arrives randomly and security prices adjust to the arrival of the news
We cannot forecast specifics of the news very accurately

41. Anomalies Definition Low PE Effect Low-Priced Stocks
Small Firm and Neglected Firm Effect
Market Overreaction
Value Line Enigma
January Effect

42. Anomalies (cont’d) Day-of-the-Week Effect Turn-of-the Calendar Effect
Persistence of Technical Analysis
Behavioral Finance
Joint Hypothesis Problem
Chaos Theory

43. Definition
A financial anomaly refers to unexplained results that deviate from those expected under finance theory
Especially those related to the efficient market hypothesis

44. Low PE Effect
Stocks with low PE ratios provide higher returns than stocks with higher PEs
And similarly for high P/B (hence lower Book/Market) stocks
Supported by several academic studies
Conflicts directly with the CAPM, since study returns were risk-adjusted (Basu)
Related to both semi-strong form and weak form efficiency

45. Low-Priced Stocks
Stocks with a “low” stock price earn higher returns than stocks with a “high” stock price
There is an optimum trading range

46. Small Firm and Neglected Firm Effects
Small Firm Effect
Neglected Firm Effect

47. Small Firm Effect
Investing in firms with low market capitalization will provide superior risk-adjusted returns
Supported by academic studies
Implies that portfolio managers should give small firms particular attention

48. Neglected Firm Effect
Security analysts do not pay as much attention to firms that are unlikely portfolio candidates
Implies that neglected firms may offer superior risk-adjusted returns

49. Market Overreaction
The tendency for the market to overreact to extreme news
Investors may be able to predict systematic price reversals
Results because people often rely too heavily on recent data at the expense of the more extensive set of prior data

50. The Value Line Enigma
Value Line (VL) publishes financial information on about 1,700 stocks
The report includes a timing rank from 1 down to 5
Firms ranked 1 substantially outperform the market
Firms ranked 5 substantially underperform the market
Victor Niederhoffer refers to Value Line’s ratings as “the periodic table of investing”

51. The Value Line Enigma
Changes in rankings result in a fast price adjustment
Some contend that the Value Line effect is merely the unexpected earnings anomaly due to changes in rankings from unexpected earnings
Nonetheless, Value Line’s successful record is evidence in support of the existence of superior analysts who apparently possess private information

52. January Effect Stock returns are inexplicably high in January
Small firms do better than large firms early in the year
Especially pronounced for the first five trading days in January

53. January Effect (cont’d)
Possible explanations:
Tax-loss trading late in December (Branch)
The risk of small stocks is higher early in the year (Rogalski and Tinic)

54. January Returns by Type of Firm
Average January return
Average January return minus average monthly return in rest of year
Average January return after adjusting for systematic risk
S&P 500 Companies
Highly Researched
2.48%
1.63%
-1.44%
Moderately Researched
4.95%
4.19%
1.69%
Neglected
7.62%
6.87%
5.03%
Non-S&P 500 Companies
Neglected
11.32%
10.72%
7.71%
Source: Avner Arbel, “Generic Stocks: The Key to Market Anomalies,” Journal of Portfolio Management, Summer 1985, 4–13.

55. Day-of-the-Week Effect
Mondays are historically bad days for the stock market
Wednesday and Fridays are consistently good
Tuesdays and Thursdays are a mixed bag

56. Day-of-the-Week Effect (cont’d)
Should not occur in an efficient market
Once a profitable trading opportunity is identified, it should disappear
The day-of-the-week effect continues to persist
However – there are confounding effects between the levels and the volatilities of returns across different days

57. Turn-of-the-Calendar Effect
The bulk of the return comes from the last trading day of the month and the first few days of the following month
For the rest of the month, the ups and downs approximately cancel out

58. Persistence of Technical Analysis
Technical analysis refers to any technique in which past security prices or other publicly available information are employed to predict future prices
Studies show the markets are efficient in the weak form
Literature based on technical techniques continues to appear but should be useless

59. Behavioral Finance
Concerned with the analysis of various psychological traits of individuals and how these traits affect the manner in which they act as investors, analysts, and portfolio managers
Growth companies will usually not be growth stocks due to the overconfidence of analysts regarding future growth rates and valuations
Notion of “herd mentality” of analysts in stock recommendations or quarterly earnings estimates is confirmed

60. Chaos Theory
Chaos theory refers to instances in which apparently random behavior is systematic or even deterministic
under Mauboussin’s theory of the market as a complex adaptive system, then we would expect to see chaotic dynamics
Econophysics refers to the application of physics principles in the analysis of stock market behavior
e.g., an investment strategy based on studies of turbulence in wind tunnels
Includes use of multifractal models

61. Are Markets Rational?
This question always faces a joint hypothesis problem:
Tests of EMH are always dual tests of both market efficiency and the specific asset-pricing model assumed
Market efficiency
Is the stock’s price equal to its true value?
Asset pricing model used (CAPM, APT, etc.)
What is the stock’s true value?
Never known for sure
“The question of value presupposes an answer to the question, of value to whom, and for what?” – Ayn Rand
E.g., the value of Apple stock would be different to Steve Jobs than to any other investor

62. Are Markets Rational? Related issue – what is information?
“Information is that which causes changes” – Claude Shannon (father of information theory)
So, if something causes the markets to move, then by definition, it must be information, and vice versa
From this perspective, the market is neither efficient nor inefficient, it just is
So, are the markets efficient or rational?
Ultimately, difficult to answer categorically
Key question is not whether or not the markets are efficient – this is a side issue – but how investors should act, given how the markets work