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Verdict on Financial Markets Efficiency?

Posted in Big Ideas, Investing Expertise

What do three prominent academic experts conclude when they review the body of evidence for and against the Efficient Markets Hypothesis (EMH), and therefore the potential benefit of speculation? In the April 2011 version of their paper entitled “Review of the Efficient Market Theory and Evidence”, Andrew Ang, William Goetzmann and Stephen Schaefer review the theoretical and empirical literature on EMH, with focus on implications for active investment management. They consider a range of markets and tests of both prices and investment managers, noting that EMH has evolved to consider the costs of collecting, analyzing and exploiting market information (trading frictions, financing costs, manager fees). Based on this literature review, they conclude that:

  • Tests of prices occasionally discover EMH violations, suggesting that active management can add value to passive diversification. However, simulations of trading strategies with historical data generally offer little out-of-sample guidance because they often incorporate data snooping bias and usually ignore trading frictions, scalability and market adaptation.
  • By exploiting generally accepted risk premiums (such as value and volatility), investment managers can beat naive benchmarks (such as simple market weighting). However, this approach is arguably passive exposure to known risk factors and not true alpha. Moreover, the popularity of indexes like the S&P 500 suggests that they are overpriced and hence “easy” benchmarks.
  • Evidence supports belief that investment managers with competitive advantages in acquiring, analyzing and trading on value‐relevant information can generate true alpha.
  • There is no evidence that potential alpha systematically decreases or increases with asset class liquidity.
  • For many alternative asset classes, the quality and duration of historical data is insufficient for reliable inference about benefits of active management. It seems that some alternative asset class managers perform well in the relative calm before 2008, but many perform very poorly during the financial crisis of 2007-2009. Specifically:
    • There is evidence that some mutual fund managers are skillful (but no compelling evidence that fund investors benefit from these skills net of fees).
    • There is evidence that some institutional managers are skillful prior to the mid-2000s (but not since).
    • There is evidence that some hedge fund managers are skillful (but doubt regarding data quality, diminishing returns to scale and negative impact of growth in assets under management).
    • There is little convincing evidence that private equity and venture capital managers are skillful.
    • There is not enough information to evaluate whether real estate managers are skillful.

In summary, evidence suggests that investing experts can generate “fake” alpha via asset class/risk factor diversification and true alpha by exploiting private value-relevant information.

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