BM410 Investments The Efficient Market Hypothesis or Is 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 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 CAL: E(r) Two Assets and the CAL (Capital Allocation Line) P E(rp) = 15% Risk premium E(rp) - rf = 8% ) S = 8/22 rf = 7% F Slope: Reward to variability ratio: ratio of risk premium to std. dev. 0 P = 22% s This graph is the risk return combination available by choosing different values of y. Note we have E(r) and variance on the axis. E(r) MPT: The Impact of Correlation 13% r = -1 r=0 r = .3 r = -1 8% r=1 TWO SECURITY PORTFOLIOS WITH DIFFERENT CORRELATIONS 12% 20% St. Dev The Efficient Frontier Efficient frontier E(r) Individual Global assets minimum variance portfolio Minimum variance frontier The minimum-variance frontier of risky assets St. Dev. E(r)The Efficient Frontier with CALs CAL (P) CAL (A) M M P P CAL (Global minimum variance) A A G F P P&F M A&F s CAPM and The Security Market Line Notice that instead of using standard deviation, the SML uses Beta E(r) SML Relationships b = [COV(ri,rm)] / sm2 SML Slope SML = E(rm) – rf = market risk premium E(rM) rf SML = rf + b[E(rm) - rf] ß ß M= 1.0 CAPM: Expected Return– Beta Relationship Expected return - beta relationship E(rM) - rf = E(rs) - rf 1 bs 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 + bs [E(rM) - rf ] APT and the Security Characteristic Line Excess Returns (i) SCL . .. . Plot of a company’s excess return as a . .. . function of the excess return of the market . . . . . .. . . . .. . . . . . . Excess returns . .. .. . . . . . .. on market index . . . .. . . .. . . . R = a + ßR + e i i i m i 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 SF SSF information — no benefit from 10Ks, 10Qs, etc. Strong form • Stock prices reflect all relevant information, Weak Form including past, public, and inside information– no benefit from any insider information Random Walk and the EMH 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 with Positive Trend Security Prices Time Efficient Markets Hypothesis and Competition Stockprices 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 Implications of EMH 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 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 Market Efficiency and Portfolio Management 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 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. C. Understand Empirical Tests of Market Efficiency Howare tests made of the Efficient Market Hypothesis? Most common are: Performance Attribution: Assessing performance of professional managers Testing of filter / trading rules Event studies 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 Event Studies How Tests Are Structured 1. 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 (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 Event Studies (continued) -t 0 +t Announcement Date Returns Surrounding the Event Final Thoughts on Market Efficiency 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 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. D. Understand Anomalies to the EMH • 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? 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 Pricesof 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?
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