Just About Everything You Wanted to Know About the Efficient Market Hypothesis

By on November 17, 2010

Philip S. Russel and Violet M. Torbey, both academics, have written an extensive article on the Efficient Market Hypothesis (EMH).

Russel and Torbey describe the three recognized forms of EMH:

First, what do we mean by an Efficient Market Hypothesis? The simplest explanation would be that securities prices reflect information. Fama (1970) made a distinction between three forms of EMH: (a) the weak form, (b) the semi-strong form, and (c) the strong form. However, it is the semi-strong form of EMH that has formed the basis for most empirical research.

The strong form suggests that securities prices reflect all available information, even private information. Seyhun (1986, 1998) provides sufficient evidence that insiders profit from trading on information not already incorporated into prices. Hence the strong form does not hold in a world with an uneven playing field. The semi-strong form of EMH asserts that security prices reflect all publicly available information. There are no undervalued or overvalued securities and thus, trading rules are incapable of producing superior returns. When new information is released, it is fully incorporated into the price rather speedily. The availability of intraday data enabled tests which offer evidence of public information impacting stock prices within minutes (Patell and Wolfson, 1984, Gosnell, Keown and Pinkerton, 1996). The weak form of the hypothesis suggests that past prices or returns reflect future prices or returns. The inconsistent performance of technical analysts suggests this form holds. However, Fama (1991) expanded the concept of the weak form to include predicting future returns with the use of accounting or macroeconomic variables. As discussed below, the evidence of predictability of returns provides an argument against the weak form.

While the semi-strong form of EMH has formed the basis for most empirical research, recent research has expanded the tests of market efficiency to include the weak form of EMH. There continues to be disagreement on the degree of market efficiency. This is exacerbated by the joint hypothesis problem. Tests of market efficiency must be based on an asset-pricing model. If the evidence is against market efficiency, it may be because the market is inefficient, or it may be that the model is incorrect. The literature documented below presents evidence of inefficiencies based on existing models and more recent research findings that cast doubt on these models.

Russel and Torbey’s paper on the EMH is lengthy and informative. I haven’t read it in its entirety but caught this while browsing it:

I. Pricing of Closed-end Funds: The Investment Company Act of 1940 regards all investment funds that do not continuously issue and redeem their shares as closed-end funds. Unlike open-end funds, closed-end funds do not stand ready to sell or repurchase their securities at the net asset value per share. [4] They float a fixed number of shares in an initial public offering and after that, investors wishing to buy or sell shares of a closed-end funds must do so in the secondary market. [5] The prices in the secondary market are dictated by the market forces of demand and supply which may not be directly linked to the fund’s fundamental or net asset value. Malkiel (1977) argues that the market valuation of closed-end investment company shares reflects mispricing. As he notes, “The pricing of closed-end funds does then seem to provide an illustration of market imperfection in capital-asset pricing.” [Malkiel, 847] In general, the funds have been shown to trade at a discount relative to their net asset values (See Malkiel, 1977; Brickley and Schallheim, 1985; Lee, Shleifer and Thaler, 1991). Between 1970 and 1990, the average discount on closed-end funds ranged between 5 to 20 percent. The existence of discounts clearly contradicts the value additivity principle of efficient and frictionless capital markets. [6] Reports from the popular press have also commented on mispricing in the closed-end fund market. As Laderman notes in Business Week (March 1, 1993), “America’s financial markets are the most efficient in the world. But there’s one corner where pockets of inefficiency still exist: closed-end funds”.

SMA Comment: It seems that efficient pricing of assets really goes out the window during periods of extreme market turbulence, like we experienced in October 2008. There were a tremendous number of closed-end funds trading at discounts to net asset value (NAV) greater than 25%. Now that market have regained their equilibrium, discounts to NAV have narrowed dramatically. This seems to be strongly contradictory to the strong form of EMH. It seems the EMH may move from weak to strong depending on the mood (and rationality) of investors.

Source: The Efficient Market Hypothesis on Trial: A Survey


  1. Anonymous

    November 22, 2010 at 6:18 pm

    Good insight. Please post more comments. They are usually more valuable than the underlying article.

  2. stocksystm

    November 24, 2010 at 2:13 am

    Thanks for the compliment. I'll be retiring at the end of the year and will have more time for my own commentary soon.

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