Market Efficiency

Market Efficiency


The effectiveness of capital markets has insinuations for the investment analysis as well as management of your portfolio. Capital markets should be proficient because many rational, profit-maximizing investors respond quickly to the issuance of new information. Presumptuous prices are a sign of new information, they are neutral approximations of the securities' true, intrinsic value, and there must be a constant relationship among the return on an investment and its risk. (Reilly F.K., and Brown K.C., n.d.)


Building on Samuelson's microeconomic approach, together with a taxonomy suggested by Harry Roberts (1967), Fama (1970) assembled a wide-ranging review of the theory and facts of market efficiency. Though his paper proceeds from theory to empirical work, he notes that most of the empirical work preceded development of the theory.

The theory involves defining a proficient market as single in which trading on hand information fails to give an abnormal profit. A market can be deemed to be efficient, therefore, only if we posit a model for returns. From this point on, tests of market efficiency become joint tests of market behaviour and models of asset pricing. We discuss this issue later.

The weak form of the efficient market hypothesis claims that prices fully reflect the information implicit in the sequence of past prices. The semi-strong form of the hypothesis asserts that prices reflect all relevant information that is publicly available, while the strong form of market efficiency asserts information that is known to any participant is reflected in market prices. The literature begins, therefore, with studies of weak form market efficiency.

Fama (1970) summarises the early random walk literature, his own contributions and other studies of the information contained in the historical sequence of prices, and concludes so as to "the results are strongly in support" of the weak type of market effectiveness. He then reviews a number of semistrong and strong form tests, highlighting those that we cover in the next two sections. He concedes, however, that "much remains to be done", and indeed, Fama (1991) subsequently returned to the fray with a reinterpretation of the proficient markets hypothesis in the guidance of subsequent research.

Studies of the semi-strong form of the efficient markets hypothesis can be categorised as tests of the speed of adjustment of prices to new information. The principal research tool in this area is the event study. An event study averages the cumulative performance of stocks over time, from a specified number of time periods before an event to a specified number of periods after.

Performance for each stock is measured after adjusting for market-wide movements in security prices. Since the first event studies, numerous papers have demonstrated that early identification of new information can provide substantial profits. Insiders who trade on the basis of privileged information can therefore make excess returns, violating the strong form of the efficient markets hypothesis. Even the earliest studies by Cowles (1933, 1944), however, make it clear that investment professionals do not beat the market.

While there was evidence on the performance of security analysts, until the 1960s there was a gap in knowledge about the returns achieved by professional portfolio managers. With the development of the capital asset pricing model by Treynor (1961) and Sharpe (1964) it became clear that the CAPM can provide a benchmark for performance analysis. The first such study was Treynor's (1965) article in Harvard Business Review on the performance of mutual funds, closely followed by Sharpe's (1966) rival article.

The most frequently cited article on fund managers' performance was to be the detailed analysis of 115 mutual funds over the period 1955-64 undertaken by Jensen (1968). On a risk-adjusted basis, he finds that any advantage that the portfolio managers might have is consumed by fees and expenses. Even if investment management fees and loads are added back to performance measures, and returns are measured gross of management expenses (ie, assuming research and other expenses were obtained free), Jensen concludes that "on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses."

Fama (1991) summarises a number of subsequent studies of mutual fund and institutional portfolio managers's performance. Though some mutual funds have achieved minor abnormal gross returns before expenses, pension funds have underperformed passive benchmarks on a risk-adjusted basis. It is important to note that the efficient markets hypothesis does not rule out small abnormal returns, before fees and expenses. Analysts could therefore still have an incentive to acquire and act on valuable information, though investors would expect to receive no more than an average net return. Grossman and Stiglitz (1980) formalise this idea, showing that a sensible model of equilibrium must leave some incentive for security analysis.

To make sense, the concept of market efficiency has to admit the possibility of minor market inefficiencies. The evidence accumulated during the 1960s and 1970s appeared to be broadly consistent with this view. While it was clear that markets cannot be completely efficient in the strong form, there was striking support for the weak and semi-strong forms, and even for versions of strong form efficiency that focus on the performance on professional investment managers.

Fama and French (1992) show that two variables, closely related to Basu's earnings and Banz's size variables, capture much of the cross-sectional variation in stock returns over the period 1963-1990. These results have been confirmed for a wide variety of non-US markets as well; see, for example, Arshanapalli, Coggin and Doukas (1998). The main finding of Fama and French is that market capitalisation and book-to-market equity subsumes the impact not only of these two variables but also of price/earnings ratios and leverage. The Fama and French result may be consistent with asset pricing theory, in which case the model can be regarded as an empirical model in the spirit of arbitrage pricing theory. Alternatively, the influence of book-to-market equity, the most powerful explanatory variable, may result from market overreaction, though the authors report that simple tests do not confirm that size and book-to-market effects are due to the type of market overreaction posited by, amongst others, DeBondt and Thaler (1985).


Taking in consideration the mixed results, it is vital to consider the implications of each and every of this for technical or primary analysts as well as for portfolio managers. The EMH points to that technical analysis must be of no value. Each and every forms of primary analysis are helpful, but they are not easy to put into practice because they entail the capability to estimate future values for pertinent economic variables. Superior study is probable but complicated because it needs superior projections. Those who administer portfolios should continually evaluate investment advice to establish whether it is superior. (Reilly F.K., and Brown K.C., n.d.)

As renowned, studies have signifies that the bulk of professional money managers can't overcome a buy-and-hold strategy on a risk-adjusted basis. One justification for this normally inferior performance is that there have no superior analysts plus the cost of research and trading influences the results of merely sufficient analysis into the inferior kind. One more explanation, which is preferred by the author and has a number of empirical evidence from the Value Line along with the analyst recommendation results, is to money management firms use both superior with inferior analysts and the advantages from the recommendations by a small amount of superior analysts are counterbalance by the costs and the poor results resulted from the proposal of the inferior analysts. (Reilly F.K., and Brown K.C., n.d.)


Arshanapalli, B., Daniel, C., and John, D. (1998). "Multifactor Asset Pricing Analysis of International Investment Strategies". Journal of Finance, July 1998.

Cowles, A. (1933). "Can Stock Market Forecasters Forecast?", Econometrica, pp. 309-324.

Cowles, A. (1944). "Stock Market Forecasting", Econometrica, pp. 206-214.

DeBondt, W and Thaler, R. (1985). "Does the Stock Market Overreact?", Journal of Finance, pp. 793-805.

Fama, E. (1970). "Efficient Capital Markets: A Review of Theory and Empirical Work", Journal of Finance, pp. 383-417.

Fama, E. (1991). "Efficient Capital Markets II", Journal of Finance, pp. 1575-617.

Fama, E., Fisher, L., Jensen, M., and Roll, R. (1969). "The Adjustment of Stock

Prices to New Information", International Economic Review, pp. 1-21.

Fama, E., and French, K. (1992). "The Cross-Section of Expected Returns", Journal of Finance, pp. 427-465.

Grossman, S., and Stiglitz, J. (1980). "On the Impossibility of Informationally Efficient Markets", American Economic Review, pp. 393-408.

Jensen, M. (1968). "The Performance of Mutual Funds in the Period 1945-1964", Journal of Finance, pp. 389-416.

Roberts, H. (1967). "Statistical Versus Clinical Prediction of the Stock Market". Unpublished manuscript, CRSP, University of Chicago, May 1967.

Sharpe, W. (1964). "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk", Journal of Finance, pp 425-442.

Sharpe, W. (1966). "Mutual Fund Performance", Journal of Business, pp 119-138

Treynor, J. (1961). "Toward a Theory of Market Value of Risky Assets". Mimeo.

Treynor, J. (1965). "How to Rate Management of Investment Funds", Harvard Business Review, (Jan-Feb), pp. 63-75.

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