The efficient market hypothesislike the random walk hypothesis it grew out ofis not so much a hypothesis as it is a model for how markets perform. As a model, it applies to some markets more than others. A market is said to be efficient if prices in that market reflect all available information. Suppose you hear that a firm has just announced quarterly earnings that exceed analysts' predictions. You rush to buy the stock but find its price has already risen two dollars from the previous day's close. Are you too late? Might the price continue to rise on the positive news, or has the market overreacted? Perhaps you should sell short instead of buying? The efficient market hypothesis says these questions are mutethat whatever information you consider in making a decision has already been incorporated into prices and is useless for predicting future prices of the stock. Market efficiency renders speculative trading pointless. We will elaborate on this shortly, but let's first consider some background. The random walk hypothesis of the early 1960s was an empirical result. Based on time-series analyses of past prices, researchers concluded that the prices behaved like geometric random walks. This threw cold water on the practice of technical analysis, suggesting the predictive price patterns technicians divined from price charts were only figments of their imagination. However, the absence of predictive price patterns does not mean that prices cannot be predicted using other information. It ruled out technical analysis but not fundamental analysis. Some of the literature supporting the random walk hypothesisespecially Alfred Cowles' workdid seem to discredit fundamental analysis as well. Rather than study time series of prices, Cowles studied the performance of investment managers and investment newsletters. Presumably, these employed a variety of analytic techniques to make stock picks. Their collective poor performance cast doubt, not only on technical analysis, but on all means of speculative trading. In the late 1960s and early 1970s, Eugene Fama's efficient market hypothesis extended the random walk hypothesis to throw cold water on all forms of analysis employed by speculative traders. Fama had helped pay his way through college by working for professor Harry Ernst, who published a newsletter recommending stock picks based on technical analysis. He gave Fama the job of studying past prices to identify profitable trading systems. Identifying systems that performed well on the historical data was easy, but they routinely failed when implemented. Fama was learning for himself what is widely know to professional investorsthat data mining can produce all sorts of trading systems that work beautifully on the data from which they are derived but are worthless otherwise. Fama took these experiences with him to the University of Chicago, where he earned a PhD in finance. His thesis was published in the Journal of Business in 1965 as the "Behavior of stock market prices." This elaborated on the random walk hypothesis, fleshing out other researchers' justification for why prices should follow a random walk. It reported on Fama's own empirical studies of past price data. Advances in computers had made it possible for him to perform more elaborate studies than earlier researchers. Fama also looked at flaws in the random walk hypothesis, focusing especially on the issue of market leptokurtosis. His overall conclusions were dismal for market technicians. The random walk hypothesis was an excellent model for the markets, and whatever flaws it might have weren't anything that would present market technicians with trading opportunities.
Although Fama's paper was about the random walk hypothesis, it is notable for introducing the term "efficient market" and anticipating the efficient market hypothesis: [1] ... a situation where successive price changes are independent is consistent with the existence of an "efficient" market for securities, that is, a market where, given the available information, actual prices at every point in time represent very good estimates of intrinsic values ... In an abbreviated version of his paper, which Fama (1965) wrote for the practitioner-oriented Financial Analysts Journal, he elaborated: [2] An "efficient" market is defined as a market where there are large numbers 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 ... on the average, competition will cause the full effects of new information on intrinsic values to be reflected "instantaneously" in actual prices. But he still held out hope for fundamental analysts: [3] ... the existence of many sophisticated analysts helps make the market more efficient which in turn implies a market which conforms more closely to the random walk model. Although the returns to these sophisticated analysts may be quite high, they establish a market in which fundamental analysis is a fairly useless procedure both for the average analyst and the average investor. This was just so much theory, unsupported by empirical facts. Fama's empirical work had exclusively looked at time series of prices, and a study of fundamental analysis would likely need to look at investment managers' performance or study security price movements following announcements, such as stock splits or earnings announcements. In 1965, the scant research along such linesCowles (1933), Friend et al (1962) and Horowitz (1963) studied investment managers' performancehad found no evidence of sophisticated analysts earning "quite high" returns. Between 1965 and 1970, many empirical studies were performed on stock price behavior or investment managers' performance. These culminated in 1970 with Fama's second landmark paper, which appeared in the Journal of Finance and was titled "Efficient capital markets: A review of theory and empirical work." In it, Fama elaborated on his theory of efficient markets and reviewed the developing literature. Based on the terminology of his colleague Harry Roberts, he reported on empirical tests for three different levels of market efficiency:
Fama's 1965 paper had explored the random walk hypothesis, and there was nothing unexpected to report in 1970. Empirical studies of the random walk hypothesis strongly supported weak market efficiency. Empirical studies of semi-strong or strong market efficiency had been made possible by the new capital asset pricing model of Sharpe (1964) and Lintner (1965). For semi-strong efficiency, this allowed researchers to disaggregate individual security's returns into a component due to broad market moves and a "residual" component specific to each security. Semi-strong efficiency was tested by assessing the behavior of those residuals leading up to and following announcements. Fama, Fisher, Jensen and Roll (1969) performed such a study around announced stock splits. Ball and Brown (1968) did so with quarterly earnings announcements. Scholes (1969) considered new stock issuances as well as large underwritten sales of existing common stock. All these studies gave strong support for semi-strong market efficiency. Fama acknowledged that strong market efficiency could not be an entirely realistic model for the markets, since certain non-public information clearly presented a profit opportunity for those who possessed it. Market makers on the New York Stock Exchange made consistent profits trading stocks due to the privileged information their positions afforded them. Corporate managers could also profit from trading based on inside information their positions made available to them (although the practice was and still is illegal in the United States). For Fama, the question was not whether the markets were strongly efficient. It was: how strongly efficient are they? [4] Since we already have enough evidence to determine that the model is not strictly valid, we can now turn to other interesting questions. Specifically, how far down through the investment community do deviations from the model permeate? Does it pay for the average investor (or the average economist) to expend resources searching out little known information? Are such activities even generally profitable for various groups of market "professionals"? More generally, who are the people in the investment community that have access to "special information"? Recent work had focused on the performance of mutual fund managers. If they were able to consistently outperform the markets, this would suggest they possessed useful insights or information. CAPM provided a framework for considering their performance on a risk-adjusted basis. This was important because managers could boost their absolute returns by merely increasing the systematic risk (beta) of their portfoliowhich had nothing to do with their ability to time the market or pick stocks. Various metrics for a manager's risk-adjusted performance were proposed, including the Treynor ratio (1965), Sharpe ratio (1966) and Jensen's alpha (1968). Fama cited all three papers, but he focused on Jensen's study of mutual funds' alphas. Jensen gathered annual return data for the S&P 500 (which he used as a proxy for the market portfolio) and 115 mutual funds. He used fund returns after fees but ignoring any sales loads. He had complete data for 1955-1964, but some funds had data going back as far as 1945, which he used as well. He performed a regression for each mutual fund to determine its alpha. His estimated alphas for all 115 mutual funds are summarized in Exhibit 1, which is reproduced from his paper.
The vast majority of the funds had negative estimated alphas, with the average being 1.1%. This means that, after fees, but not including sales loads, the average fund underperformed the overall market by 110 basis points a year. Looking at fund returns before fees, the results were only marginally better. Then a majority still had negative estimated alphas, but with the average being 0.4%. Jensen noted [1] An examination [of the data] ... reveals only 3 funds which have performance measures which are significantly positive at the 5% level. But before concluding that these funds are superior we should remember that even if all 115 of these funds had a true α equal to zero, we would expect (merely because of random chance) to find 5% of them or about 5 or 6 funds ... at the 5% level.
Jensen's study and others like it were a devastating blow to the investment management industry. In 1971, Wells Fargo Bank established the first indexed portfolio for a single pension fund client. More passively-managed portfolios, and even indexed mutual funds, soon followed. Such funds generally have no loads, low fees and, because they buy and hold the securities comprising specific equity indexes, minimal transaction costs. Their custody fees are often lower as well. Consistent with Jensen's findings, index funds have routinely outperformed actively managed funds. Fama's efficient market hypothesis has been an extremely influential theory. Investors are well advised to accept it unequivocally because violations that are significant enough to afford trading opportunities are 1) rare, 2) likely illegal, and 3) if not illegal, unlikely to be advertised to the retail or institutional investing public, anyway. One of the oldest questions to plague Wall Street brokers is: if their investment ideas (technical analysis, stock tips, buy-write programs, etc.) are so good, why do brokers give the ideas away rather than invest their own money in them? But violations of strong or semi-strong efficiency have been documented. There is even a literature on market anomalies, documenting violations of weak efficiency, although these generally are too minor to afford profit opportunities after transaction costs. Jones and Litzenberger (1970) published one of the first significant violations of semi-strong efficiency. Suspecting that the markets respond slowly to unexpectedly good earnings announcements, they constructed portfolios of stocks that had recently announced such earnings and found that the portfolios outperformed the overall market in subsequent months. The phenomenon was observable in every one of ten overlapping periods they considered between 1964 and 1967, and it was significant enough to earn excess returns after transaction costs. Financial institutions have also identified a few violations of semi-strong efficiency over the years. Not surprisingly, they didn't give these gems away to clients. The firms kept quiet and reaped profits for themselves. One such opportunity was pairs trading, which Morgan Stanley exploited in the 1980s. Another was fixed income arbitrage, which Salomon Brothers had a team of professionals exploit a decade later. Such violations don't last, since traders soon exploit the opportunities out of existence. Don't try pairs trading. The technique is so widely known today that there are books on the subject. I doubt anyone has made a dime from it in the last ten years. As for fixed income arbitrage, the Salomon team set up their own hedge fund, Long-Term Capital Management (LTCM), in the early 1990s. But by then, other hedge funds and brokers were also getting involved in fixed income arbitrage. Profits were tight and LTCM dabbled in other, unproven speculative trading strategies. Market turmoil, combined with the fund's leverage, inflicted massive losses, and LTCM failed in 1998. Today's boom in hedge funds in not a violation of the efficient market hypothesis. There is no evidence that hedge funds consistently outperform the market. There is tremendous hype over unsubstantiated claims and flawed industry studies that purport that they have. The studies are based on incomplete performance data compiled in ways that are known to introduce biases. If nothing else, the efficient market hypothesis has demonstrated how rare it is to consistently outperform the markets, so there is something peculiar about the thousands of hedge funds being started up each yeareach year taking the place of other thousands of hedge funds that are quietly shut down without any public explanation. Brokers and hedge fund managers are getting rich off the hedge fund boom, but investors are not. The efficient market hypothesis has never been much of a
match for the marketing machine of Wall Street. Still, it has had more influence than most academic theories. Today,
many billions of dollars
are invested in index funds. The efficient market hypothesis is also
kept before the public with Burton Malkiel's popular book
A Random Walk Down Wall Street
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A
market has 
.
The engrossing book targets
Malkiel,
Burton (1973). 
