2017 Level I Exam

Market Efficiency

THE CONCEPT OF MARKET EFFICIENCY

Description of Efficient Markets
An informationally efficient market has prices that reflect all past and present information. If
markets are highly efficient, passive strategies are the best. Active investment strategies should
prevail in inefficient markets.

Prices can incorporate new information only as fast as trading mechanisms allow. In developed
equity markets this could be less than a minute. The markets should only react to unexpected
information. Anticipated news should already be built into the price.

Market Value versus Intrinsic Value

Market value is the price at which assets currently trade. The price represents the intersection of
supply and demand. Intrinsic value (or fundamental value) is the value calculated by investors
with complete knowledge. The intrinsic value is still an estimate because the future is always
uncertain. Efficient markets will have market prices that closely mirror intrinsic value.

Factors Contributing to and Impeding a Market's Efficiency

Market Participants
More investors will increase the efficiency in a market, allowing price changes to more quickly
reflect new information. Also, more financial analysts following a security will increase its
efficiency.

Information Availability and Financial Disclosure

More available information and financial disclosure will increase market efficiency. Securities
traded on major exchanges have much information available. Dealer and over-the-counter (OTC)
markets vary greatly in the amount of information provided. Regulators desire "fair" markets that
provide the same information to all investors. This is why insider trading is prohibited.

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Limits to Trading
Arbitrageurs contribute to market efficiency by quickly exploiting mispriced securities. If trade
execution is slow or expensive, arbitrageurs will be hindered in their transactions. Short selling
limitations also restrict arbitrage trading. It is a primary means used by arbitrageurs to exploit
securities that are overpriced.

Transaction Costs and Information-Acquisition Costs

Efficiency must be measured in light of transaction costs. If the difference in prices between two
identical securities selling in different markets is less than the trading costs, then arbitrage does
not exist. Thus the markets are still efficient.

Expenses are incurred to acquire information. The active investment return must at least
compensate for the expenses required to gather the information necessary to execute the strategy.

FORMS OF MARKET EFFICIENCY

Eugene Fama developed a framework for describing the degree of market efficiency. Below is a
table summarizing his framework.

Market Prices Reflect:

Form of Market Past Market Data Public Private

Efficiency Information Information

Weak X

Semi-strong X X

Strong X X X

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Weak Form
Security prices reflect all past market trading data. Can test this form of efficiency by looking for
patterns is past prices. If patterns exist that are pronounced enough to allow for arbitrage profits,
then the market is not weak form efficient. Technical analysis relies on trading rules to exploit
weak form inefficiency. Technicians propose market participants trade in part based on
psychological motives. Evidence supports weak form efficiency in developed markets.

Semi-Strong Form
Security prices reflect all publicly available information, including past market trading data.
Public information also includes financial statement data. If a market is semi-strong form
efficient then it is weak form efficient also. In this type of market, analyzing public reports is a
waste of time and money because the information is already fully built into the security price.

Event studies are used to measure semi-strong form efficiency. The test analyzes the market's
reaction time to company announcements and events. If the market is semi-strong form efficient,
the market will react quickly and fully to the new information. If it is not semi-strong form
efficient, abnormal positive or negative returns will persist for a longer period of time after the
announcement. Most studies have supported semi-strong form efficiency in developed markets.

Strong Form
Security prices fully reflect public and private information. A strong-form efficient market is also
semi-strong and weak-form efficient. Insider trading would not be profitable in a strong-form
efficient market. However, many studies have shown investors with inside information do earn
abnormal profits. The conclusion is that markets are not likely to be strong-form efficient. This is
why most markets have laws against insider trading.

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Implications of the Efficient Market Hypothesis

Fundamental analysis process of examining public information and generating forecasts will
not generate abnormal returns if a market is semi-strong efficient. However, this process keeps
the market semi-strong efficient. It can still be profitable if the analyst gains a comparative
advantage.

If markets are weak-form efficient, technical analysis will not generate abnormal profits.
Technicians continue to search for market inefficiencies, which help markets stay weak-form
efficient.

Many studies have shown active portfolio managers do not beat the market on average. When
fees are considered, investors would be better off using passive strategies. Portfolio managers
could still add value by designing investment strategies that are consistent with the client
objectives, risk preferences and tax situation.

MARKET PRICING ANOMALIES

Researchers have found many potential inefficiencies, or anomalies, in markets. An anomaly
occurs if security price changes cannot be linked to new information. Some are discovered
incorrectly through a process called data mining, it which past data is scrutinized looking for any
patterns. If you torture the data long enough, it will confess! Such discoveries are not likely to
persist into the future.

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Time-Series Anomalies
Calendar Anomalies
Returns in the first few trading days of January are abnormally high, especially for small firms.
Some suppose this January effect is due to investors selling losers in December to capture capital
losses for tax purposes. Others have proposed portfolio managers sell riskier securities at the end
of December to make their holdings appear safer. Recent evidence indicates this anomaly is no
longer present.

Other calendar anomalies include turn-of-the-month effect (returns higher at end and beginning
of months), day-of-the-week effect (average Monday return is negative), weekend effect
(weekend returns are lower than weekday returns), and holiday effect (returns on day before
holiday are greater).

Momentum and Overreaction Anomalies

Some studies have shown markets overreact to good and bad news. This could be exploited by
purchasing past losers and selling past winners, which is a contrarian investment approach.
Studies have also shown security prices tend to go up and down in runs over short-term periods.
This momentum could simply be adjustments to market consensus growth rates.

Cross-Sectional Anomalies
Small-cap companies have outperformed large-cap companies on a risk-adjusted basis. This size
effect has not been observed in studies since 1981. Value stocks (below average price-to-
earnings and market-to-book ratios) have consistently outperformed growth stocks. This
outperformance could be due to extra risk.

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Other Anomalies
Closed-End Investment Fund Discounts
Shares of closed-end funds trade on stock markets like other equity securities. Most trade at a
sizable discount to their net asset value (NAV). Researchers have proposed this is due to
projected management fees or performance, hidden tax liabilities, or illiquidity. However, none
of the explanations seem to explain the full discount. The anomaly is not exploitable because the
transaction costs required to buy and liquidate the fund would eliminate any profits.

Earnings Surprise
Many studies have shown companies with positive surprise earnings announcements experience
a prolonged period of abnormal positive security returns. An efficient market should react
immediately. Transaction costs and risk may prevent exploitation.

Initial Public Offerings (IPOs)

The initial selling price for IPOs is often set too low by investment banks. This is not surprising
since investment banks want to make sure they can sell the entire offering. Investors can often
make quick, substantial profits in IPOs. However, long-term IPO performance is often below
average. Investors may be overly optimistic.

Predictability of Returns Based on Prior Information

Many researchers have documented equity returns are linked to factors including interest rates,
inflation rates, volatility, and dividend yields. But the relationships are not consistent over time,
so arbitrage is not possible.

Implications for Investment Strategies

Some argue most of the anomalies detected are based on poor statistical methods. Also,
overreactions and under-reactions are present in the market, which means the market is efficient
on average. Trading costs and risk exposures prevent many of the anomalies from being
exploited.

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BEHAVIORAL FINANCE
Behavioral finance observes how human behavior affects financial markets. The focus is on
inherent cognitive biases that affect decision making. Assuming market rationality does not
imply all investors are rational.

Loss Aversion
Most financial models assume investors are risk averse. That means investors will only take on
risk if they expect additional compensation. Behaviorists argue investors really just dislike losses
(e.g. they are fine with winning the lottery). This loss aversion could lead to overreactions in the
markets.

Herding
Herding behavior has been used to explain under reactions and over reactions in financial
markets. Investors tend to go with the flow rather than use their private information.

Overconfidence
People are often overconfident in their own abilities. This can lead to temporary mispricing of
securities. However, because this mispricing is tough to predict it is unlikely investors can earn
abnormal profits because of it.

Information Cascades
With information cascades, those who act first will pass on information that influences others.
This could explain short-term serial correlations in stock returns. Information cascades can
enhance the information available to traders, but they are not always correct.

Other Behavioral Biases

Representativeness rely too much on current state when assessing probabilities

Mental accounting keep track of gains in losses separately for different investments

Conservatism slow to make changes

Narrow framing focus on issues in isolation

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