Strong-form Efficiency

Strong form is the top level of Fama's efficient market hypothesis. It says prices reflect all information. That covers three layers:

• past market data (the weak form);
• all public information (the semi-strong form);
• insider information as well.

So its claim is very broad. No group of investors should be able to earn returns above average, after allowing for risk, again and again. That includes analysts. It includes fund managers. It even includes company insiders.

It is best seen as where the idea leads if you follow it all the way. Most people do not expect real markets to meet it. Think about what it means. If insiders cannot profit from what only they know, prices must somehow already contain it.

The workbook's statement: strong-form EMH "encompasses the weak-form hypothesis as well as semi-strong-form hypothesis" and "contends that no group of investors should be able to derive above-average risk-adjusted rates of return".

The workbook reports that evidence on the EMH overall is mixed — some studies support efficiency, others reveal anomalies — and that active managers use anomaly-based strategies in the hope of earning alpha.

For a portfolio manager, the practical constraint on inside information is regulatory rather than theoretical. The XXI-B chapter on regulatory, governance and ethical aspects (Chapter 11) requires unpublished price sensitive information (UPSI) to be handled on a need-to-know basis, uses pre-clearance of trades with a declaration that the applicant does not possess UPSI, and requires information barriers (Chinese walls). Strong-form efficiency asks whether such information is already in prices; securities law does not permit anyone to test that by trading on it.

Illustrative figures. A listed engineering company's board is negotiating to sell a division. Only a handful of people — directors, bankers, lawyers — know. The deal implies the stock is worth about ₹520. It trades at ₹400.

In a strong-form efficient market, the information would somehow already be reflected — the stock would sit near ₹520 before the announcement, and the insider's purchase would earn only a normal return.

The common observation that prices do jump when deals are announced is precisely why strong-form efficiency is the hardest form to accept. For a portfolio manager, the example is also a compliance scenario: a professional who came to know of the negotiation would be in possession of UPSI and could not deal in the stock at all.

Chapter 13 (Concept of Informational Efficiency), section 13.2.3, defines the strong form and its relationship to the weak and semi-strong forms; section 13.3 notes that the evidence on EMH is mixed. Expect recall questions on what information each form covers and which forms a given form encompasses. Chapter 11 supplies the regulatory treatment of the insider information the strong form refers to.

• Strong form covers insider information. Semi-strong stops at public information.
• Strong form encompasses both weaker forms — if strong-form holds, weak and semi-strong must also hold.
• "No group of investors" — the strong form's claim extends to insiders, not just to outside analysts.
• Above-average risk-adjusted returns are ruled out, not positive returns.
• Market efficiency is a hypothesis about prices, not a legal permission. Trading on UPSI is prohibited regardless of whether a market is judged efficient.