Informational Efficiency — can anyone beat the market?

Two kinds of "efficient"

The word efficiency means two different things in markets. The exam expects you to separate them.

The rest of the chapter is about informational efficiency.

What an efficient market really is

Common definition: a market in which prices always "fully reflect" the most up-to-date information — so market price equals fair value.

Technical definition: a market in which the market price is an unbiased estimate of the true value.

That second definition is subtler, and it is the one that gets tested. In an efficient market, price need not equal value. Price can be above or below value, as long as the deviations are:

• random — an equal chance of being under- or over-valued at any moment; and
• uncorrelated with any observable market variable.

The consequence: no investor can consistently find under- or over-valued securities, using any strategy, to earn abnormal returns. The workbook's examples: a stock with a PEG ratio below 1.0 is no more or less likely to be undervalued than a stock with a high PEG; and no technical indicator would reliably identify mispriced stocks.

Market price versus intrinsic value

• Market price — the price at which a security is currently available to buy or sell.
• Intrinsic value (also called fundamental value) — the value investors would place on the asset if they fully understood its investment characteristics: financials, promoters and management, SWOT, the sector and the company's place in it, competitive advantage, and macro-economic factors. All of this feeds an estimate of future cash flows.

Intrinsic value can only ever be estimated, never known for certain.

What investors do depends on what they believe:

Random walk and Fama's EMH

The early efficient market model rested on the Random Walk hypothesis: security price changes occur randomly. If price fully reflects available information, then successive one-period returns are independent and identically distributed — a random walk.

Early work was mostly empirical. In 1970, Eugene Fama formalised the theory and organised the evidence. He described the Efficient Market Hypothesis (EMH) as a fair game model: the current price fully reflects all available information, so the expected return is consistent with the security's risk. No strategy or tool can deliver above-average risk-adjusted returns — investors get normal returns for the risk they take.

Fama split the EMH into three sub-hypotheses, by the information set involved.

The three forms of efficiency

Each form nests the one before it. If a market is strong-form efficient, it must also be semi-strong and weak-form efficient. The reverse is not true.

Under the weak form, current prices are completely independent of past prices — which is sufficient to show that prices follow a random walk.

What the evidence says

The evidence on the EMH is mixed. Some studies support it. Others have found anomalies — market behaviour inconsistent with existing risk-and-return models. Those anomalies gave rise to popular investment strategies that active portfolio managers use to seek alpha.

Three market anomalies

January effect

Observed in the US market. Investors sell losing stocks towards year-end to book tax losses, then buy back the same or similar stocks after the new year. Result: downward pressure on prices in late November and December, upward pressure in early January. Other investors exploit this by buying in December and selling in January. This predictable pattern is inconsistent with the EMH.

The US IRS responded with the wash sale rule: a wash sale occurs when someone sells securities at a loss and, within 30 days before or after the sale, buys substantially identical securities (or acquires them in a fully taxable trade, or gets a contract or option to buy them). Losses on wash sales cannot be deducted.

Size anomaly

Small firms have consistently earned larger risk-adjusted returns than large firms (size measured by total market value). This contradicts market efficiency. Small-cap portfolios are a direct outcome of this anomaly.

Value anomaly

There is a positive relationship between the book-value-to-price ratio and future returns. Stocks with a high book-to-price ratio have delivered superior risk-adjusted returns. Since book-to-price is public information, this contradicts the EMH. This anomaly is at the heart of the popularity of value investing.

What efficiency means for portfolio management

Technical analysis

Technical analysts use past price, return and volume data to predict future prices. If the market is weak-form efficient, past returns tell you nothing about future returns, so trading rules based on past market data should gain little. The workbook puts it strongly: the EMH renders technical analysis completely irrelevant for superior returns.

Fundamental analysis

The semi-strong form says prices adjust rapidly and accurately to all public information. Fundamental analysts value securities using publicly available information. So if a market is semi-strong efficient, trading on public information will not produce superior risk-adjusted returns — prices already reflect the news.

The internal contradiction

Markets do not become efficient on their own. They become efficient because participants, believing the market is not efficient, hunt for mispricing and trade on information to beat the market. So the necessary condition for efficiency is that many profit-maximising participants believe the market is inefficient. That is the internal contradiction in the concept of efficiency — and it is why efficiency requires a deep and liquid market.

The rise of index funds

Passive AUM in index funds has grown significantly worldwide. One explanation is market efficiency: in an efficient market, minimising transaction costs beats frequent trading, especially for long-term investors. The logic of indexing is: when it is difficult to beat the market, be with the market and reduce transactions — cutting transaction costs and tax, so returns are better to begin with.