Efficient Market Hypothesis Explained | CFA Level I Equity Investments

In this lesson, we will dive into the Efficient Market Hypothesis (EMH) and its implications for investment managers and analysts

Understanding the Efficient Market Hypothesis (EMH)

The Efficient Market Hypothesis (EMH) was originally developed by Professor Eugene Fama. According to the theory, markets are efficient when prices reflect all relevant information at any point in time. Such relevant information can be categorized into 3 distinct sets:

1. All relevant information, including both public and private information
2. Public information only, such as financial statement data, company announcements, analyst reports, and past market data
3. Past market data only, which refers to all historical price and trading volume information

EMH defines 3 forms of market efficiency with respect to these sets of information:

1. Weak-form market efficiency: Current market prices fully reflect all past market data. Technical analysis cannot generate abnormal returns in such a market.
2. Semi-strong form market efficiency: Prices reflect all publicly known and available information. Investors cannot achieve positive risk-adjusted returns using fundamental analysis.
3. Strong-form market efficiency: Security prices fully reflect both public and private information. Even insiders with material private information would not be able to earn abnormal returns. However, this level of efficiency is unrealistic due to insider trading restrictions.

Testing Market Efficiency

Tests for market efficiency typically involve calculating abnormal profits, which are positive risk-adjusted returns. If the abnormal profit is found to be statistically significant, we can reject the hypothesis of efficient prices with respect to the information on which the strategy is based.

Weak-Form Efficiency Tests

Weak-form efficiency can be tested using trading strategies based on technical analysis. Tests have shown that technical analysis does not produce abnormal profits in developed markets, implying weak-form efficiency. However, it has had some success in emerging markets, suggesting they may not be as weak-form efficient as developed markets.

Semi-Strong Form Efficiency Tests

Semi-strong form efficiency can be tested using trading strategies based on fundamental analysis, such as event studies. Evidence in developed markets indicates that they are generally semi-strong form efficient, while some emerging markets show evidence of semi-strong form inefficiency.

Implications for Investors

In markets that are weak-form and semi-strong form efficient, active trading using fundamental or technical analysis is unlikely to generate abnormal returns. Instead, investors should consider passive investing, such as investing in an index fund that replicates the returns on a broad market index. Studies have shown that most mutual fund managers cannot consistently outperform a passive index strategy.

Despite these findings, the role of a portfolio manager is still valuable in helping clients with portfolio diversification, asset allocation according to their risk profile, and tax management.