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Market Efficiency

1. Performance of portfolio managers2. Anomalies3. Behavioral Finance as a challenge to the

EMH

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2. Performance of Portfolio Managers

Implication of the semi-strong form EMH: managers cannot consistently beat the market

Information set of managers: (supposedly) public information

Collectively, U.S. evidence based on this type of tests support the semi-strong form EMH

Issue of survivorship bias

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Canadian Evidence

Largest 76 Canadian equity funds from 1988 to 1997, none beat the category average in all ten years

Canadian Investment Review, Fall 2002, “Does Aggressive Portfolio Management Work?”Market timing test: non-linear regression covered in

classStock selection ability test: Jensen’s alpha

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Performance of Portfolio Managers

Conclusion: no evidence of consistent market-timing or stock-picking abilities

And “past performance is not an indicator of future performance”

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3. AnomaliesExceptions that appear to be contrary to

market efficiencyEarnings announcements affect stock prices

Adjustment occurs before announcement, but also significant amount after

Contrary to efficient market hypothesis because the lag should not exist

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Anomalies: Examples

Low M/B ratio stocks tend to outperform high M/B ratio stocksLow M/B portfolios typically have higher risk-

adjusted returns (risk measured by or constant )Value investingWhy is it an anomaly?

M/B is public information!

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Canadian Evidence(Deaves 2005)

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Anomalies: Examples

Size effect Tendency for small firms to have higher risk-adjusted

returns than large firmsJanuary effect

Tendency for small firm stock returns to be higher in January

Half of the size premium can be accounted for in January (known as Small-firm-in-January effect)

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Anomalies: ExamplesTime trendEvidence of short-term momentum (3-12 month

horizon) in stock pricesBut evidence of long-term reversal (3-5 year horizon) in

winner and loser portfolios

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Explanations for Anomalies

Risk Premiums or market inefficiencies?Data mining or anomalies?

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The Value PremiumRisk-based explanation

Relax the assumption in the conventional CAPM that beta and the market risk premium are constant

HML has higher beta when market risk premium is high. Translation: value stocks do not do well in down markets, and hence are riskier to investors (Petkova and Zhang 2005)

Value firms tend to have greater amounts of tangible assets, and hence less flexibility to adjust capacity during downturns (operating risk)

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The Value Premium

Behavioral finance explanation: Investors tend to overreactGrowth stocks are glamour stocksPrice bidded up beyond fundamental valueCorrection in the long termOpposite is true for value stocks

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4. Behavioral Finance

Behavioral finance: provides an alternative view of financial marketsChallenges the EMH on both theoretical and empirical

groundsTheory: model investor behavior, using theories and

observations from the psychology literatureEmpirical: existence of anomalies (anomalous from the

EMH perspective)

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Three Theoretical ChallengesI. Investors can be irrational

Trade on irrelevant information (noise) Trade on sentiment Follow advice of financial gurus Fail to diversify Over-active trading

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Theoretical Challenges

II. Irrational investors’ trades are not random If random and uncorrelated, tend to cancel each other

out, so that on average, stock price = fundamental price

Behavioral finance: irrational investors’ trades are positively correlated, and hence move in the same direction

Investor sentiment reflect common judgment errors made by a substantial number of investors

Listen to the same rumours, and imitate neighbours04/21/23

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Theoretical Challenges

III. There are limits to arbitrage If there is a significant number of irrational investors,

arbitrage is risky If arbitrageurs are risk-averse, their activities will be

limited (fundamental risk, implementation costs, model risk)

Mispricing can exist, particularly in the short term

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