1. Slide 9-1 Market Efficiency 1. Performance of portfolio managers 2. Anomalies 3. Behavioral Finance as a challenge to the EMH 1/7/2016 1

2. Slide 9-2 2. Performance of Portfolio Managers Implication of the semi-strong form EMH: managers cannot consistently beat the market Information set of managers: (supposedly) public information Collectively, U.S. evidence based on this type of tests support the semi-strong form EMH Issue of survivorship bias 1/7/2016 2

3. Slide 9-3 Canadian Evidence Largest 76 Canadian equity funds from 1988 to 1997, none beat the category average in all ten years Canadian Investment Review, Fall 2002, “Does Aggressive Portfolio Management Work?” Market timing test: non-linear regression covered in class Stock selection ability test: Jensen’s alpha 1/7/2016 3

4. Slide 9-4 Performance of Portfolio Managers Conclusion: no evidence of consistent market- timing or stock-picking abilities And “past performance is not an indicator of future performance” 1/7/2016 4

5. Slide 9-5 3. Anomalies Exceptions that appear to be contrary to market efficiency Earnings announcements affect stock prices Adjustment occurs before announcement, but also significant amount after Contrary to efficient market hypothesis because the lag should not exist 1/7/2016 5

6. Slide 9-6 Anomalies: Examples Low M/B ratio stocks tend to outperform high M/B ratio stocks Low M/B portfolios typically have higher risk- adjusted returns (risk measured by  or constant  ) Value investing Why is it an anomaly? M/B is public information! 1/7/2016 6

7. Slide 9-7 Canadian Evidence (Deaves 2005) 1/7/2016 7

8. Slide 9-8 Anomalies: Examples Size effect  Tendency for small firms to have higher risk-adjusted returns than large firms January effect  Tendency for small firm stock returns to be higher in January  Half of the size premium can be accounted for in January (known as Small-firm-in-January effect) 1/7/2016 8

9. Slide 9-9 Anomalies: Examples Time trend Evidence of short-term momentum (3-12 month horizon) in stock prices But evidence of long-term reversal (3-5 year horizon) in winner and loser portfolios 1/7/2016 9

10. Slide 9-10 Explanations for Anomalies Risk Premiums or market inefficiencies? Data mining or anomalies? 1/7/2016 10

11. Slide 9-11 The Value Premium Risk-based explanation Relax the assumption in the conventional CAPM that beta and the market risk premium are constant HML has higher beta when market risk premium is high. Translation: value stocks do not do well in down markets, and hence are riskier to investors (Petkova and Zhang 2005) Value firms tend to have greater amounts of tangible assets, and hence less flexibility to adjust capacity during downturns (operating risk) 1/7/2016 11

12. Slide 9-12 The Value Premium Behavioral finance explanation: Investors tend to overreact Growth stocks are glamour stocks Price bidded up beyond fundamental value Correction in the long term Opposite is true for value stocks 1/7/2016 12

13. Slide 9-13 4. Behavioral Finance Behavioral finance: provides an alternative view of financial markets Challenges the EMH on both theoretical and empirical grounds Theory: model investor behavior, using theories and observations from the psychology literature Empirical: existence of anomalies (anomalous from the EMH perspective) 1/7/2016 13

14. Slide 9-14 Three Theoretical Challenges I. Investors can be irrational  Trade on irrelevant information (noise)  Trade on sentiment  Follow advice of financial gurus  Fail to diversify  Over-active trading 1/7/2016 14

15. Slide 9-15 Theoretical Challenges II. Irrational investors’ trades are not random If random and uncorrelated, tend to cancel each other out, so that on average, stock price = fundamental price Behavioral finance: irrational investors’ trades are positively correlated, and hence move in the same direction  Investor sentiment reflect common judgment errors made by a substantial number of investors  Listen to the same rumours, and imitate neighbours 1/7/2016 15

16. Slide 9-16 Theoretical Challenges III. There are limits to arbitrage  If there is a significant number of irrational investors, arbitrage is risky  If arbitrageurs are risk-averse, their activities will be limited (fundamental risk, implementation costs, model risk)  Mispricing can exist, particularly in the short term 1/7/2016 16