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

BM410 Investments

The Efficient Market Hypothesis

orIs there really a free lunch?

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

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

E(r)E(r)

E(rE(rpp) = 15%) = 15%

rrff = 7% = 7%

= 22%= 22%00

PP

FF

PP

) S = 8/22) S = 8/22

E(rE(rpp)) - - rrff = 8% = 8%

CAL: (Capital

AllocationLine)

Two Assets and the CAL

Slope: Reward to variability ratio: ratio of risk premium to std. dev.

Risk premium

This graph is the risk return combination available by choosing different values of y. Note we have E(r) and variance on the axis.

r = 0

E(r)

r = 1r = -1

r = -1

r = .3

13%

8%

12% 20% St. Dev

TWO SECURITY PORTFOLIOS WITH DIFFERENT CORRELATIONS

MPT: The Impact of Correlation

E(r)

The minimum-variance frontier of risky assets

Efficientfrontier

Globalminimumvarianceportfolio Minimum

variancefrontier

Individualassets

St. Dev.

The Efficient Frontier

E(r)

CAL (Globalminimum variance)

CAL (A)CAL (P)

M

P

A

F

P P&F A&FM

A

G

P

M

s

The Efficient Frontier with CALs

E(r)

E(rM)

rf

SML

Mßß = 1.0

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

SML = rf + b[E(rm) - rf]

CAPM: Expected Return–Beta Relationship

Expected return - beta relationship

E(rM) - rf = E(rs) - rf

1 s

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 + s [E(rM) - rf ]

APT and the Security Characteristic Line

Excess Returns (i) SCL

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.. ...... .... .... ..

Excess returnson market index

Ri = a i + ßiRm + ei

Plot of a company’s excess return as a function of the excess return of the market

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

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

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

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

Random Walk and the EMH

Security Security PricesPrices

TimeTime

Random Walk with Positive Trend

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

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

Questions

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

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.

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.

B. 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

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

Implications of EMH Efficiency

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

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

Market Efficiency and Portfolio Management

Questions

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

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.

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.

How are tests made of the Efficient Market Hypothesis? Most common are:

Performance Attribution: Assessing performance of professional managers

Testing of filter / trading rulesEvent studies

C. Understand Empirical Tests of Market Efficiency

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.)

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

How Tests Are Structured1. 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

Event Studies

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

00 +t+t-t-t

Announcement DateAnnouncement Date

Returns Surrounding the Event

Event Studies (continued)

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

Final Thoughts on Market Efficiency

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

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

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.

• 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?

D. Understand Anomalies to the EMH

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.

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

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)

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

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

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.

Answer #3

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

Questions

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

Problem #4

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

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.

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!!!!!!!

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?