The Efficient Market Hypothesis - Case Study Example

Topic: As the Capital Markets are efficient, no one can earn abnormal returns .Certainly there is any point to pay a fund manager to manage your investment portfolio. INTRODUCTION: An efficient market is defined as a market where there are large number of rational, profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which, as of now, the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value. (Efficient Market Hypothesis. 2001). The Efficient Market Hypothesis is one of the cornerstones of modern financial economics. The efficient market hypothesis (EMH) is the idea that information is quickly and efficiently incorporated into asset prices, so that old information cannot be used to foretell future price movements. The random walk model of asset prices is an extension of the EMH, as are the notions that the market cannot be consistently beaten, arbitrage is impossible, and "free lunches" are generally unavailable. The three forms of EMH are weak, semi-strong and strong forms. The weak-form EMH stipulates that current asset prices already reflect past price and volume information chart data. Consequently, trend analysis is useless for predicting future price changes. The semi strong-form EMH states that all publicly available information is similarly already incorporated into asset prices, and so a firm’s financial statements are of no help in forecasting future price movements and securing high investment returns. The strong-form EMH stipulates that private information too, is quickly incorporated by market prices and therefore cannot be used to reap abnormal trading profits. (Feinstein 2000). In an efficient market, all relevant information is fully and immediately reflected in a security’s market price, thereby assuming that an investor will obtain an equilibrium rate of return. An investor should not expect to earn an abnormal return (above the market return) through either technical analysis or fundamental analysis. In weak form stock prices reflect all past information in prices. In semi –strong form the stock prices reflect all past and current publicly available information. In strong form the stock prices reflect all relevant information, including information not yet disclosed to the general public, such as insider information. (Efficient Market Hypothesis). The security prices reflect the information available in an efficient capital market, i.e., all publicly available information in the market will have a hand in security prices .There are no under valued or overvalued securities and thus trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated in to the price rather speedily. The accumulating evidence suggests that stock prices can be predicted with a fair degree of reliability .The predictability results from time varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk undertaken. However the predictability of stock return reflects the psychological factors and social movements. The efficient market hypothesis asserts that the current market prices on traded assets like stocks, bonds or properties already reflects the total knowledge and expectation of all investors .It is unlikely that anyone investor could use the information available to consistently produce above market returns .Efficient market hypothesis is important to understand as it explains the factors which led to outerformance of passive managed funds over active managed funds. The costs of research and management included in active management of funds will have to be recouped from the investment income .In active management of funds, superior performance can be achieved only through the research specifically by identifying mispriced investments and taking advantage of them. The remuneration of the fund manager will also to be paid from the investment income .In the passive investment of funds there is no such extra costs. (Efficient Market Hypothesis (EMH). 2008). The concept efficient market hypothesis is built on assumptions of investor rationality. According to John M. Keynes ,investors are guided by short –run speculative motives .They are not interested in assessing the present value of future dividends and holding an investment for a significant period, but rather in estimating the short run price movements. In the EMH, investors have a long term perspective and the return on investment of fund is determined by a rational calculation based on changes in the long run income flows. However in the Keynesian analysis, investors have shorter horizons and returns represent changes in short run price fluctuations. Capital markets have evolved as highly liquid institutions wherein individual investors can transact at will. Given that transactions occur in an uncertain environment, it is legitimate to hypothesize an element of speculation in trading. It is evident that many investors do not buy stocks for keeps but rather to resell them in the very near future in the hope of making a gain. (Russel and Torbey 2002). The stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, the stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices .As such it should be impossible to outperform the overall market through expert stock selection or market timing and that the only way that investors can possibly obtain higher returns is by purchasing riskier investment. (Efficient Market Hypothesis (EMH). 2008). It is evidenced that the securities markets were extremely efficient in reflecting information about individuals stocks and the stock market as a whole .The accepted view is that when information arises, the news spread very quickly and is incorporated in to the prices of securities without delay .Thus the technical analysis or fundamental analysis would not be helpful to an investor to achieve returns greater than those that could be obtained by holding a randomly selected portfolio of individual stocks at least not with comparable risk. (Malkiel 2003). The three forms of EMH: In weak-form efficiency capital market, no excess returns can be earned by using investment strategies based on historical share prices or other financial data. Weak-form efficiency implies that not technical analysis techniques will be able to consistently produce excess returns. In a weak-form efficient market current share prices are the best, unbiased, estimate of the value of the security. Theoretical in nature, weak form efficiency advocates assert that fundamental analysis can be used to identify stocks that are undervalued and overvalued. Therefore, keen investors looking for profitable companies can earn profits by researching financial statements. In semi-strong form efficiency capital market, the share prices adjust instantaneously and in an unbiased fashion to publicly available new information, so that no excess returns can be earned by trading on that information. Semi-strong-form efficiency implies that fundamental analysis techniques will not be able to reliably produce excess returns. To test for semi-strong-form efficiency, the adjustments to previously unknown news must be of a reasonable size and must be instantaneous and consistent upward or downward adjustments after the initial change must be looked for. If there are any such adjustments it would suggest that investors had interpreted the information in a biased fashion and hence in an inefficient manner. In strong-form efficiency capital market, the share prices reflect all information and no one can earn excess returns. To test for strong form efficiency, a market needs to exist where investors cannot consistently earn excess returns over a long period of time. When the insider trading is introduced, where an investor trades on information that is not yet publicly available, the idea of a strong-form efficient market seems impossible. Studies on the US stock market have shown that people do trade on inside information. It was also found though that others monitored the activity of those with inside information and in turn followed, having the effect of reducing any profits that could be made. The role of the fund manager: The fund manager trades the underlying securities of the mutual funds, realising capital gains or losses and passing any proceeds to the individual investors. The decisions of the fund manager regarding the investment of funds need not always helpful to make profit in capital market. The features of the efficient capital market restrict the fund manger to formulate appropriate policies for gaining abnormal profit from the capital market. The results imply that performance relative to the market is more or less normally distributed, so that a certain percentage of managers can be expected to beat the market. Given that there are tens of thousand of fund managers worldwide, then having a few dozen star performers is perfectly consistent with statistical expectations. (Asset Allocation Basics: Part VI Efficient Market Hypothesis. 2006). If markets are sometimes inefficient, and stock prices a flawed measure of value, corporate boards and management teams would have to rethink the way they compensate executives and judge their performance. Michael Jensen, a retired Harvard economist who worked on efficient-market theory earlier in his career, notes a big lesson from the 1990s was that overpriced stocks could lead executives into bad decisions, such as massive over-investment in telecommunications during the technology boom. (The Kinda-eventually-sorta-mostly-almost Efficient Market Theory. 2004). In an efficient financial market, an asset’s price should be the best possible estimate of its economic values. A financial market is information ally efficient when market prices reflect all available information about value. Implications of EMH: 1. Trust market prices. • Buying and selling assets are zero NPV activities, giving only risk-adjusted returns. • Market prices give best estimate of value for projects. • Firms receive “fair” value for securities they issue. 2. Read into prices. • If market price reflects all available information, we can extract information from prices. 3. There are no financial illusions. • Market price reflects value only from an asset’s payoff. • It is not easy to trick the market. 4. Value comes from economic rents such as superior information, superior technology, and access to cheap resources etc. (Chapter 13: Efficient Market Hypothesis. 2003). Mr. Market and EMH: The EMH asserts that at any time the price of a stock on a stock market reflects all information about that stock and about that market, including any and all future expectations. That, in effect, Mr. Market knows everything before others do and in much more detail. The basic premise of the hypothesis is that every piece of information about the market has already been collected and analyzed by vast majority of investors and this information is always reflected correctly in the price of any stock. The problem with the hypothesis is that most investors (either individuals or institutional) in fact base their expectations on past prices and company performance--by analyzing the historical data, or the company fundamentals. (Efficient Market Hypothesis Rebuttal. 2001). Do Fund Managers Systematically Outperform the Market? In our description of the efficient market hypothesis, we drew a distinction between a strong version of the hypothesis, in which asset prices fully reflect all available information, and a weaker, but economically more realistic, version in which prices reflect information only to the extent that there remain net benefits to collecting it. Managed funds provide an interesting test of this distinction; Investors employ active managers who devote significant resources to uncovering information and whose performance can be compared with alternative passive strategies (such as buying-and-holding the market). The strong version of the efficient market hypothesis predicts that actively managed fund returns will equal passive returns before deducting management expenses, while the weaker version suggests that they will equal passive returns after deducting management expenses. The consistency of fund performance is a relevant issue... Although funds on average may fail to add value, this may not be true for all of them. It does appear that some fund managers have consistently performed better than their peers It remains unclear why underperforming funds survive in the marketplace. Poor performance does increase the probability of a fund being eliminated from the market. However, it is difficult for potential users of fund management services to identify the better managed funds. Consistent with this is the observation that fees vary little across actively managed funds, implying that better performing funds are not in a position to profit from their better track records. Funds also go to lengths to differentiate their products, preventing simple comparisons of portfolio returns. In response to the generally poor performance of actively managed funds, there has been a marked rise in the quantity of funds invested passively. Overall then, the performance of actively managed funds is broadly supportive of the efficient markets hypothesis. After deducting management fees, actively managed funds usually do not outperform passively managed funds. (Beechey, Gruen and Vickery 2000). Present Scenario:- The prices of securities react very quickly to new information about their value even before it is officially made public In fact, the market often anticipates and reacts to news before it is officially made public. For example, General Motors announced a major restructuring in December 1991, closing twenty-one factories and cutting seventy-four thousand jobs. On the day of the announcement GMs stock price fell by only 0.4 percent because the market had already incorporated expectations about the restructuring into its price. The market reacted only to the difference between the anticipated news and what was actually announced. Stock prices react quickly, in the expected direction, to the release of information. Stock prices react within ten minutes to an earnings announcement, it is in this environment of relatively low-cost information and active security analysis that the theory of efficient capital markets has developed. (Jones and Netter 1999-2002). Conclusion: In the context of EMH, the investors in the capital market can attain their normal profit goals through the gathering of relevant information available from various sources .Due to the investors’ perspective and the speedy transmission of market developments through the break- through in information technology the role of funds manager has become irrelevant .In an efficient capital market no one can earn abnormal returns due to the specific feature of the EMH as explained above .In efficient capital market , the efficiency of the fund manager will not be helpful to the investor to achieve profit above the normal rate . So investors prefer to use their own individual skills on investment decisions in capital markets instead depending on a third person like fund manager. The investor has easy access to the performance of the market shares through the media. There are short term courses on portfolio management which are open to the investors. By attending such courses the investors can acquire skills in port folio management. , so that the services of a fund manager can be dispensed with. Thus the remuneration to be payable to the fund manager may be retained with the investor. Bibliography Efficient Market Hypothesis. (2001). [online]. Everything. Last accessed 15 May 2008 at: http://www.everything2.com/title/Efficient%2520Market%2520Hypothesis FEINSTEIN, Steven P (2000). Teaching the Strong-Form Efficient Market Hypothesis and Making the Case for Insider Trading – A Classroom Experiment. [online]. Journal of Financial Education. Last accessed 15 May 2008 at: http://faculty.babson.edu/feinstein/EMH_JFED_20000308b.doc Efficient Market Hypothesis. [online]. ADVFN ill , India. Last accessed 15 May 2008 at: http://www.advfn.com/money-words_term_6818_Efficient_Market_Hypothesis.html Efficient Market Hypothesis (EMH). (2008). [online]. Moolanomy. 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Last accessed 15 May 2008 at: http://bigpicture.typepad.com/comments/2004/11/the_mostlykinda.html Chapter 13: Efficient Market Hypothesis. (2003). [online]. Lecture Notes. Last accessed 15 May 2008 at: http://web.mit.edu/15.407/file/Ch13.pdf Efficient Market Hypothesis Rebuttal. (2001). [online]. Everything. Last accessed 15 May 2008 at: http://www.everything2.com/e2node/efficient%2520market%2520hypothesis%2520rebuttal BEECHEY, Meredith. GRUEN, David and VICKERY, James (2000). The Efficient Market Hypothesis: A Survey. [online]. Economic Research Department. Reserve Bank of Australia. Last accessed 15 May 2008 at: http://www.rba.gov.au/rdp/RDP2000-01.pdf JONES, Steven L and NETTER, Jeffry M (1999-2002). Efficient Capital Markets. [online]. The Concise Encyclopedia of Economics. The Library of Economics and Liberty. Last accessed 15 May 2008 at: http://www.econlib.org/library/Enc/EfficientCapitalMarkets.html Read More