Introduction

The question of market efficiency has troubled academics for as long as the markets themselves. With ‘beating the market’ the goal of every active fund manager, the answer has important implications for the investment industry. So are markets really efficient?

The Efficient Market Hypothesis

A natural beginning for this question is ‘the efficient market hypothesis’ (“EMH”), a financial theory about the market price of stocks. Its main idea is that market prices incorporate all publicly available information. In other words, in an efficient market, the price of an asset reflects the market’s best estimations of not only the present value of the stock but also the future value too. Public information can range from press releases to fundamental stock analysis (analysis of financial statements and industry trends which aims to find the intrinsic value of a company [1]). Theoretically, if the information is available somewhere, it will be known to the market and hence reflected in the stock’s price.

For the active investment management industry, market efficiency has severe implications. Namely, if the EMH holds, managers cannot individually select stocks to beat the market consistently. Achieving a positive alpha (a measure of abnormal returns – it can be interpreted as beating the market) over the long run is impossible. This theory does not argue an investor cannot achieve returns higher than the market, just that this cannot be done consistently over a long period. Fund managers can be lucky one year, but unlucky in the next. Therefore, the EMH argues that active management is a waste of time and money and individual stock selection is useless as all available information is incorporated in current prices. Instead, the EMH advocates passive investment strategies as the optimal investment technique.

Evidence of Efficient Markets

Although simple in concept, confirming whether markets are efficient is much more difficult. For example, what is the correct price of a stock? Models can be used in this estimation (like CAPM), but these models are only valid in an efficient market. Hence the fundamental testing issue.

Despite the difficulties testing efficiency, we can observe whether the implications of an efficient market occur in real life. For example, are fund managers able to outperform and beat the market? If managers can do this (consistently), this is a sign that markets may not be efficient.

The figure below shows the percentage of actively managed funds in the U.S. that underperform when compared to the S&P 1500 index.

This index is composed of U.S. stocks and is about 90% of the total U.S. market capitalisation (i.e. the value of the companies in the index total about 90% of the value of all listed U.S. companies). The size of this index makes it a good indicator for ‘the market’. The figure shows that every year, a large proportion of active funds (charging active management fees) achieve lower returns than the market which investors can cheaply replicate through an index tracker (and in 2011 and 2014 this percentage was over 80%!). The exact percentage varied each year but an average of 50% each year seems fair.

This supports the idea of market efficiency. If prices reflect all available information, then there is a 50/50 chance that a stock goes up or down as new information is unpredictable. Therefore it seems fitting that around half of funds get lucky and the other half do not. The consistent underperformance across the industry supports the EMH. If professionally managed funds are unable to beat the market, then it must be pretty efficient right?

Evidence Against Market Efficiency

Despite the consistent underperformance of professional funds, there are also observable characteristics that signal inefficiencies like exploitable patterns in stock prices. An example is the momentum effect where, in the short run, past winners continue to rise, and past losers continue to fall. Jegadeesh and Titman (1993) found that a long-short portfolio formed completely using past prices would’ve earned an average return of 12% per year over their study. This effect is known to investment firms. In fact, there is an iShares ETF designed solely to exploit ‘world stocks that have been experiencing an upward price trend’. The existence of this type of fund is a direct violation of market efficiency. If returns can be made purely by reviewing past performance, all available information cannot be incorporated into prices. Other anomalies also exist that cannot be explained in an efficient market, such as systematic long-run price reversals or post-earnings announcement drifts.

Where Do Investors Stand on Market Efficiency?

To understand perhaps investors’ view of market efficiency, we can observe the composition of the investment industry. Those who believe in market efficiency may be more drawn to passive investment strategies whilst those who believe the market can be beaten may be more likely to invest in active management. The graph below shows over the last 10 years the size of the passive industry quadrupled in the U.S. It began the decade as a fraction of the active industry but by the end of 2020, it was worth nearly the same. Passive management, as predicted by the EMH, is becoming a more substantial part of the investment industry as more products become available.

Coincidently though, we do not observe a decrease in funds actively managed. Despite a decreasing overall proportion of the funds, over the last decade the value of actively managed funds doubled in the U.S. If markets are indeed efficient, does that mean $8trn worth of funds is being invested sub-optimally?

The Fundamental Stalemate in Market Efficiency Debate

To answer this question it is important to know how markets become efficient (i.e. how do prices reflect available information).

Imagine stock X is underpriced or, given all information, it is cheap. This is a profit opportunity for investors given the stock will rise in the future, so investors flock to purchase it. This raises demand, increasing the stock’s price until it is no longer profitable to purchase. The price where investors stop purchasing reflects the fair value. The opposite is true of overpriced stocks but instead, investors short the stock increasing supply. In a market with millions of participants, this correction process can happen almost instantaneously as investors’ desire for profit ensures that these opportunities are short-lived and prices accurately reflect current information.

This correction is a result of the active management process. Therefore active management is a necessity in ensuring market efficiency. But at the same time, efficient markets discourage active management. Hence the unfortunate stalemate. Efficiency cannot happen without active management. But active management is not profitable in an efficient market.

Lasse Heje Pedersen, sums the state of efficiency up well, describing markets as ‘efficiently inefficient’. Markets are efficient in that prices generally reflect available information, and it is difficult to profit from active management. However, the market is ultimately inefficient enough to incentivise some active management that exploits profit opportunities. This means there is still some active research that can be profitable and mispricings can be corrected.

Despite the evidence both for and against market efficiency, Pedersen’s definition is perhaps the best we can come up with for now. Until more reliable models or more robust testing has been developed, we must simply be content with the age-old answer to most questions in finance and economics when discussing market efficiency… ‘it depends’.

The only thing certain is, whether markets are efficient or not, consistently beating the market remains a near-impossible task.

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