The Efficient Markets Hypothesis

Review of Empirical Financial Economics

Stephen J. BrownNYU Stern School of Business

Major developments over last 40 years

Portfolio theory

Major developments over last 40 years

Portfolio theory Asset pricing theory

Major developments over last 40 years

Portfolio theory Asset pricing theory Efficient Markets Hypothesis

Major developments over last 40 years

Portfolio theory Asset pricing theory Efficient Markets Hypothesis Corporate finance

Major developments over last 40 years

Portfolio theory Asset pricing theory Efficient Markets Hypothesis Corporate finance Derivative Securities, Fixed Income Analysis

Major developments over last 40 years

Portfolio theory Asset pricing theory Efficient Markets Hypothesis Corporate finance Derivative Securities, Fixed Income Analysis Market Microstructure

Major developments over last 40 years

Portfolio theory Asset pricing theory Efficient Markets Hypothesis Corporate finance Derivative Securities, Fixed Income Analysis Market Microstructure Behavioral Finance

The EMH was responsible for the GFC

“Neo-liberal policy prescriptions flow from the core theoretical belief in the superiority of unregulated markets - particularly unregulated financial markets. These claims ultimately rest on the "efficient-markets hypothesis", which, in its strongest form, claims that financial-market prices, like stock-market prices, incorporate all available information, and therefore represent the best possible estimate of asset prices. It follows, therefore, that if markets are fully efficient and prices fully informed, there is no reason to believe that asset-price bubbles are probable; and if these do occur, markets will self-correct; and that there is therefore no justification for government intervention to stop them occurring”

Kevin Rudd The Monthly 42 (February 2009)

The EMH was responsible for the GFC

“The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. ‘Surely, none of this could be happening in a rational, efficient world,’ they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking.”

Jeremy Grantham (quoted in the New York Times June 5, 2009)

Grantham’s performance over GFC

Sharpe Ratio

Alpha (market benchmark)

Alpha (Fama French 3 factor)

GMO US Equity Allocation Fund; Class III Shares -0.284 -0.00288 (-0.94) -0.00264 (-0.80)

GMO Tobacco-Free Core Fund; Class III Shares -0.268 -0.00215 (-0.71) -0.00261 (-0.81)

GMO US Quality Equity Fund; Class VI Shares -0.245 -0.00113 (-0.31) -0.00043 (-0.11)

GMO US Quality Equity Fund; Class V Shares -0.245 -0.00112 (-0.30) -0.00041 (-0.10)

GMO US Quality Equity Fund; Class IV Shares -0.246 -0.00116 (-0.31) -0.00045 (-0.12)

GMO US Quality Equity Fund; Class III Shares -0.247 -0.00121 (-0.33) -0.00050 (-0.13)

GMO Tax-Managed US Equities Fund; Class III Shares -0.318 -0.00473 (-1.62) -0.00435 (-1.40)

GMO US Growth Fund; Class M Shares -0.276 -0.00258 (-0.86) -0.00339 (-1.15)

GMO US Core Equity Fund; Class M Shares -0.301 -0.00388 (-1.46) -0.00392 (-1.37)

GMO US Core Equity Fund; Class VI Shares -0.295 -0.00353 (-1.32) -0.00355 (-1.23)

GMO US Core Equity Fund; Class IV Shares -0.295 -0.00357 (-1.33) -0.00359 (-1.24)

GMO US Core Equity Fund; Class III Shares -0.296 -0.00362 (-1.36) -0.00363 (-1.26)

GMO US Intrinsic Value Fund; Class III Shares -0.353 -0.00736 (-2.44) -0.00708 (-2.30)

GMO US Small/Mid Cap Growth Fund; Class III Shares -0.306 -0.00591 (-1.24) -0.00894 (-2.21)

S&P500 Market -0.236

Data from August 07 – May 09 from CRSP Mutual Funds Database

Efficient Markets Hypothesis

No trader’s information gives them an advantage

If information is already incorporated in price itz

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Brown, Stephen J. 2011 The Efficient Markets Hypothesis: The demise of the Demon of Chance? Accounting and Finance 51 79-95. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1508702

Examples of EMH applications

Weak form Efficient Markets Hypothesis Example: trading rule tests Does active management outperform passive benchmark?

Semi-strong form EMH Example: Event studies What information releases are material to investors?

Empirical asset pricing Example: Orthogonality condition in GMM Can we explain cross sectional dispersion in required return?

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good news

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Efficient Markets Hypothesis

Tests of Efficient Markets Hypothesis Does the market efficiently process information? What is information?

Estimation of parameters Does the market efficiently price risk? What determines the cross section of expected returns?

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Efficient Markets Hypothesis

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Random Walk Hypothesis

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Random Walk Hypothesis

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“The series looks like a ‘wandering’ one, almost as if once a week the Demon of Chance drew a random number from a symmetrical population of fixed dispersion and added it to the current price to determine the next week’s price”

Kendall (1953)

Random Walk Hypothesis

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Serial Correlation tests

Variance ratio tests

Random Walk Hypothesis

Serial Correlation tests

Variance ratio tests

Momentum

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Random Walk Hypothesis

Well established statistical properties

Strong assumption of stationarity

Time varying conditional expectations not allowed

Neither necessary nor sufficient for EMH

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Trading rule tests of EMH

Timmerman (2007) survey Naïve models using past sample means hard to beat Recent financial data is most relevant Short lived episodes of limited predictability

Predictability is not profitability Necessity: Do not consider all possible patterns of returns Sufficiency: Cannot profit if all markets rise and fall together

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sellz hold

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Examining profitability

Appearance of short term profitability ..

at the expense of significant downside risk(Goetzmann et al. 2008)

Benchmark

Portfolio

Société Générale Jan 2008 Jérôme Kerviel

Nick Leeson

An important seminal reference …

Trading Rules: Cowles 1933

Cowles, A., 1933 Can stock market forecasters forecast? Econometrica 1 309-325

William Peter Hamilton’s Track Record 1902-1929 Classify editorials as Sell, Hold or Buy

Novel bootstrap in strategy space

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sellE r E r hold

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Return on DJI

Trading rule predicting sign of excess returnJanuary 1970 - December 2005

Factor-augmented AR logit based on prior 120 month rolling window

Trading rule valueS&P500 value

Cowles BootstrapJan 1970-Dec 2005

Annualized excess fund return 2.203%Sharpe ratio of fund 0.063Sharpe ratio of S&P500 0.049

Peseran & Timmermann (1992) p-value 4.83%Cowles bootstrap p-value 6.32%

Bottom line: is EMH useful?

For whom is the EMH true?

Uninformed investors with limited capital? Large well informed and well endowed investors?

Does it have practical implications?

Benchmark comparisons for fund investors? What information is material to investors? Useful measures of risk and investment risk premia?

The EMH was not responsible for GFC

Banks invested in beta, thinking it was alpha

They borrowed to invest in market risk

Significant debt exposure at cusp of crisis

Banks failed to predict the collapse of the market

A direct implication of the EMH