EFFICIENT MARKET HYPOTHESIS
In the strong form of the EMH, it states that all information, both public and private, is reflected in a securities price and that an investor cannot gain an advantage over the market through ANY analysis since the markets participants know all the relevant information. The weak form focuses on publicly available information and says that this is fully incorporated into market prices. However private information, such as that held by insiders, can make a difference. But since the public is not privy to this information, a passive approach- as with the strong form- is what an investor should do. The weak form however says that while historical information is contained in the securities price and that technical analysis is worthless, that fundamental analysis of current events might provide come accurate forecasts into the future pricing. Whether one can accurately do this is another item, but the weak form says that it is possible. Further, a study by Brinson, Hood and Beebower in 1986 of 91 large pension plans from 1974- 1983 showed that an asset allocation mix dominated market timing and security selection in generating market performance. The use of a proper allocation mix explained 94% of the variation of return while active management provided just 1.10%. As Roger Gibson noted in his book, "Asset Allocation: Balancing Financial Risk", "traditionally, money management has been equated with security selection and market timing. Ironically, it is because of the tremendous intelligence and skill of the investment professionals engaging in these activities that the probability is so low. Yet, the choice of asset category and their respective weights in a portfolio has had, and will continue to have, a large impact on future performance. To many, it is surprising that over time, investment policy decisions regarding the choice of investment asset categories and their relative long term weightings have a much greater impact on their portfolios future performance than does the shifting of money among the asset categories and the selection of securities within asset categories". This rationale is the main reason why one might use index funds- since one cannot outperform the market without taking additional risk. That's why they have become so popular in the last few years- even with portfolio managers.
One must also address the need to change a mix when the economy changes.
The process is called rebalancing. Per professors Stine and Lewis, "the passive
portfolio must be rebalanced to maintain a level of risk exposure consistent
with the investors objectives. In most cases, the investor would be advised
to rebalance only when the portfolio reaches a predetermined level of risk
exposure rather than to make adjustments on a calendar basis. This has the
advantage of producing a narrower range of possible stock weights and, in
most cases, requires fewer rebalances. This was shown to hold over investment
horizons of 3, 5, 10, 15 and 20 years. A reasonable strategy is to rebalance
whenever the stock weights vary 7.5% to 10% from their original position.
This strategy does better than annual rebalancing. However, if the portfolio
manager elects to follow a calendar strategy, rebalancing quarterly or
semi-annually is too frequent and the annual rebalancing strategy appears
to produce the best result".
EFFICIENT MARKET THEORY: This long time theory tests whether
all information about a stock, bond or company is instantaneously available
to all interested parties at the same time (strong form) or whether there
is other information which is available only to certain other investors on
which they have a trading advantage (weak form). In the latter case, it might
be said that insider information is available to corporate officers and that
they DO have information not normally available to the general public and
on which they can make additional gains beyond anyone else (though it is
illegal). Most commentary seems to work towards a more efficient market,
but I will make note of an issue that is usually not addressed per se in
the text book writings. While all parties may have the SAME information,
it does NOT mean that all parties have the same capabilities in ANALYZING
the information nor that they would employ even the same formulas or other
criteria in the evaluation. Therefore, while the market may be efficient-
or at least close to- the parties analyzing the info are NOT efficient. It
is this difference in manager capabilities that one might seek. Again, most
authors state that it is impossible to predict who these performers/managers
might be and that everything in the market is simply a crapshoot. If you
agree with this philosophy, then index funds are certainly the better way
to go. However if one was able to select certain managers that had shown
previous high performance, then there is a possibility that they might be
able to do so for some time in the future. Statistics do point out that the
a high return on a portfolio in one year is in no way a prediction that it
would be the high performer in the next year. But it is also true that many
of these funds actually do better than an index fund in the next year- and
perhaps several years, though they may not be the top performer in their
grouping. But what's wrong with that if one is able to pick a higher return
for at least some period of time? Of course the next consideration is how
long might that last. Forever? No, of course not. But if one was able to
determine the impact of certain issues upon the market, then you might be
able to "ride the wave" for awhile. The problem goes further however in that
the gross return may be greater than an index, but the net return will almost
unquestionably be lower. Why? Invariably the funds with the higher returns
will have a portfolio turnover at least equal to the average of about 75%-
probably more. So you will undoubtedly have a LOT of short term gains taxed
as ordinary income as well as regular long term capital gains. By the time
you factor those costs in, you are probably going to be well below what an
index might provide. Next we have the risk. Look at tech funds before 2000.
Huge returns greater than the S&P 500. But the risk was twice as much.
Then it tanks. Lastly, how much is your time worth in analyzing and changing
funds based solely on past performance? Add all this together and you may
find the analysis may work only in theory.
RANDOM WALK
Also within this discussion is the well known, but more recently well criticized, theory of random walk. Unless some more information is provided into the marketplace, prices are solely random and cannot be predicted. However many recent studies- provided through the ability of computers- show that certain predictions are possible. Computer analysis has found mounting evidence that markets follow the same principles of behavior as physical structures such as molecules or the human brain. There are four methods that Financial World noted that traders are reviewing.
Chaos: Systems such as ocean currents or weather might seem to be random, but they actually follow a set of rules. One is the trend that once a cycle begins, it's behavior is predictable until something happens to stop it (Greenspan). People buy because prices rise and their buying cause further price increases and so on and so on until the unexpected happens (Greenspan's second and third increase of interest rate rise).
Neural Networks: These a computer programs that try to mimic the human brain. They act like technical analysts seeking patterns in trading that foretell market moves. But the computer can do it faster and consider more alternatives.
Genetic Algorithms: These are programs that mimic the evolution of living organisms. Supposedly, markets, like living organisms, have memories and behavior evolves on the basis of experience. The algorithms find patterns of behavior and predict how they will evolve- and how market will behave under new circumstances
Microstructure Analysis: This reviews how markets change as the
environment changes.
FOREIGN MARKET EFFICIENCY: In studies for the CFA, I encountered this commentary from one text. One author in foreign investment strategy states that there really is NO diversification in the use of foreign investments since they are directly correlated with U.S. stocks. This goes against almost all comments on asset allocation and the use of random or negatively correlated investments. As proof however, he also pointed out that , except for Japan, the EAFE index turned in an average exactly that of the U.S. market in the 1968- 89 (though simply having the same return says nothing about correlation per se). He also noted that costs for investing are also higher (witness the higher expense ratios in any of the foreign mutual funds). So why bother at all? Because the markets there are INEFFICIENT and produce opportunities that are not normally found in the U.S. He also points out that it makes no sense to index inefficient markets since to do so would tend to make it more homogeneous and EFFICIENT, thereby reducing returns overall. Also foreign stock markets indexes are poorly constructed because of cross ownership which overstates the market. In summary, it says to me that you need to find the country that you think will move the most for whatever reason. But then when gains are made, GET OUT since a longer time frame flattens the inefficiencies.
EFFICIENT MARKET THEORY (1997) The commentary on whether the market or a part of it can be predicted or whether it is entirely a crapshoot will go on forever. However, if you read What Works on Wall Street, you can undoubtedly conclude that certain sections of the market do indeed produce higher returns than others. Anyway, according to the Efficient Market Theory and comments from the Investors Chronicle, "there is a trade off between risk and return in the efficient market The rationale is that every investor evaluates stocks for high prospective returns and low risk. After performing an analysis on a given stock the analyst comes up with a particular price. Then the weighted average of the opinions of many different investors determines the price in the market for that stock. Any over or under estimates would be randomly distributed and small in magnitude. If another stock has the same return but at a projected lower risk, then that stock would sell at a higher price and conversely. There is a tradeoff between risk and projected return which does not allow for excess profits to me made in the long run.
Value investing is finding those supposed stocks that are worth substantially more than what they are worth (Ben Graham). Graham also felt that growth stocks were extremely risky and overpriced. Yet the most substantial returns of the last few years has been the big capitalization (growth) stocks that he dismayed.
So in simplistic terms, does value investing outproduce other types of investing? Yes- but with a caveat, just like the recent comments on small cap stocks. Given any period, a particular type of investing will outproduce others. If you can find/analyze those companies that have the potential to grow beyond current value, higher than average returns are possible. So does that automatically negate the EMT. Not necessarily. The market is relatively efficient. But the little gaps that we are now seeing have become statistically viable due to the ability of the computer to massage vast amounts of data to find these niches. But as more and more computers and formulas are used to analyze the same data, perhaps there will be fewer exceptions overall. However, where the analysis is still limited (emerging markets for example) the EMT may be held in poor esteem.
EFFICIENT MARKET: (1999) I have commented in the past that, while there is a fundamental to the efficient market where "all" information is known at "all" times and that no direct patterns should be evident, there are inconsistencies in this formula and that certain predictable trading patterns have actually emerged. Business Week noted that an anomaly is the momentum effect. That means if certain stocks or funds show consistent returns for a period of time- say 6 months- they tend to continue that momentum for another 6- 12 months while losers keep losing. Why? Economists say that information does not really get out to all participants at the same time. In reviewing small cap companies from 1980 to 1996, they noted that information about small companies is diffused slowly while info on large companies is "instant". For stocks with a market cap of $100 million, buying the top winners and shorting the worst losers netted a return of 8.3% in six months; stocks in the $500 million range gained 5.3%; stocks in companies over $5 billion earned nothing. They also noted that companies followed by fewer analysts did better at 15% for 12 months and 20% for two years while the higher covered stocks did 10% after 12 months. Lastly, an interesting comment. Past losers lost less than past winners tended to rise. "Companies are a lot less eager to let out bad news than good news and the lack of an analyst coverage probably allows then to keep it under wraps." But their study went "way " back to 1980. Considering the size and change of the market now and what I feel is far more coverage of smaller companies, I am not so sure the study is as valid. However I have no direct info to contradict the study.
INEFFICIENT MARKET: (1999) Past teachings almost always reflected an efficient market a fact that the market was entirely random in its movement since all participants has the same information at the same time and no particular difference could be identified. That has been proven false to at least some degree and now we have a researcher say that the use of IRA accounts around tax time has a positive move on the market. The average annual return in the first two weeks of April since 1978 was 20.7%. The average of the last two weeks of April was 13.6% which is roughly equal to the 14% total market return of the last 20 years.
EFFICIENT MARKET THEORY: (Boston FED 1999)- The EMT prediction is that no index portfolio earns an unusual return on a risk adjusted basis and that each index receives returns determined solely by the riskiness of that portfolio.
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Understand all that and know how to use it? Well, that's not the point. The point is that at least you or your advisor are aware of the fundamentals of investing and the variations in interpretation. And from there you can make rational decisions for investing.
SUNNY EMT: Efficient market theory (2001) : Supposedly every element about a company is known instantaneously by all entities at all times. So nobody gets any better benefit in analyzing a stock or getting a better price. But a study shows that, city by city stock markets rise more often on days when the sun shines in the morning than when skies are overcast. The study, "Good Day Sunshine: Stock Returns and the Weather," is by two finance professors, David Hirshleifer of Ohio State University and Tyler Shumway of the University of Michigan.
Inefficient Markets (2003) Andre Shleifer A review of his book. Interesting commentary
Efficient Market (Malkiel pdf 2005) In recent years, many financial economists have come to question the efficient market hypothesis. At least ex-post, there seem to be several instances where market prices failed to reflect available information. Moreover, periods of large-scale irrationality, such as the technology-internet “bubble” of the late 1990s extending into early 2000, have convinced many analysts that the efficient market hypothesis should be rejected. In addition, financial econometricians have suggested that stock prices are, to a significant extent, predictable on the basis either of past returns or of certain valuation metrics such as dividend yields and price-earning ratios.
I am increasingly convinced that the best investment advice for both individual and institutional equity investors is to buy a low-cost broad-based index fund that holds all the stocks comprising the market portfolio. If prices were often irrational and if market returns were as predictable as some critics of the efficient market hypothesis believe, than surely actively managed investment funds should easily be able to outdistance a passive index fund that simply buys and holds the market portfolio.
Index funds tend to outperform by 2% points comparison of returns: Average equity fund versus indexes
10 Years to 12/31/03 20 Years to 12/31/03
S&P 500 index 10.99% 12.78%
Average equity fund 8.47% 10.54%
S&P 500 advantage (percentage points) 2.52 2.24
Source: Lipper, Wilshire, & the Vanguard Group.
The typical active mutual fund has an expense ratio of just less than 150 basis points. Index funds can be run with minimal expense ratios less than 20 basis points, even for small individual investors. In addition, active managers turn over their portfolio—often as much as 100% each year.
Although it is true that in any period there are some active managers who do achieve returns higher than the index, it is not possible to tell in advance who they will be. There is not sufficient persistence in performance to be able to chose winning managers by an examination of their past records. The 10 best actively managed funds during the 1960s achieved rates of return almost double that of the index but those same funds underperformed the index during the decade of the 1970s. Similarly, the best funds of the 1970s underperformed during the 1980s and the winners of the 1980s achieved below average returns during the 1990s.
Past performance does not predict future returns. The ratings of professional investment
services do no better. Morningstar provides an excellent information service for investors showing the past returns, expense ratios, risk levels, and considerable additional information regarding mutual funds. The service also provides a rating for each fund with four and five star ratings indicating those funds favored for purchase.Unfortunately, while highly starred Michelin Guide restaurants guarantee the diner an excellent meal, four, and five star Morningstar ratings do not provide mutual fund investors with above-average returns. As Figure 2 shows, the highest-rated Morningstar funds substantially underperform the broad Wilshire 5000 stock-market index.
The inconsistency of mutual fund performance
4 Years 4 Years
12/31/1995 12/31/1999 12/31/1999 12/31/2003 1999–2003 Rank
Fund name Annual tot return Annual tot return (710 total funds )
RS Inv: emerg gr 51.09 -16.83 681
Janus twenty 47.56 -17.84 692
PBHG: sel growth: PBHG 43.55 -21.28 705
Janus mercury 42.23 -15.54 671
Fidelity new milliennium 42.23 -4.09 379
Fidelity aggr grow 41.63 -25.89 707
Van Kampen emerg gro; A 40.77 -15.49 668
WM: growth; A 40.71 -16.81 680
Van Kampen emerg gro; B 39.68 -16.14 675
Janus enterprise 38.43 -20.15 703
Morg stan inst: MC Gr; I 38.25 -10.44 586
Janus venture 37.88 -14.23 654
IDEX: Jan growth; T 37.57 -16.84 682
Legg Mason value Tr; Prm 37.35 -0.50 258
IDEX: Jan growth; A 37.29 -17.23 687
MFS mass inv gro; A 37.12 -11.53 605
Morg stan spec gr; B 36.69 -26.76 708
Janus growth and income 36.39 -7.18 496
Vanguard growth equity 35.00 -14.51 660
Fidelity OTC 34.72 -12.77 633
Average—top 20 39.81 -15.10
S&P 500 index 26.39 -5.34
Vanguard 500 index fund 26.35 -5.41
*Group includes General Equity funds with more than $100 million in assets as of 12/31/1995.
The evidence is overwhelming that active equity management is, in the words of Ellis (1998), a “loser’s game.”
My comment: His statements are valied- save for the fact that why would you stay in a losing position bogle, you won't hage the after 2000. Malkiel, Bogle et al do not reflect the need to get out of a 1973/74 and a 2000/02. No, I was not out right after March 2000- but I did opt out soon thereafter and used bonds. My clients MADE money in 2001, 2002.
Experts' earning forecasts: bias, herding and gossamer information, Olivier Guedj, Jean-Philippe Bouchaud (2006)
We study the statistics of earning forecasts of US, EU, UK and JP stocks during the period 1987-2004. We confirm, on this large data set, that financial analysts are on average over-optimistic and show a pronounced herding behavior. These effects are time dependent, and were particularly strong in the early nineties and during the Internet bubble. We furthermore find that their forecast ability is, in relative terms, quite poor and comparable in quality, a year ahead, to the simplest `no change' forecast. As a result of herding, analysts agree with each other five to ten times more than with the actual result. We have shown that significant differences exist between US stocks and EU stocks, that may partly be explained as a company size effect. Interestingly, herding effects appear to be stronger in the US than in the Eurozone. Finally, we study the correlation of errors across stocks and show that significant sectorization occurs, some sectors being easier to predict than others. These results add to the list of arguments suggesting that the tenets of Efficient Market Theory are untenable.