Market Efficiency

Welcome to the eleventh blog post of: Podcast of the Week. Thanks for reading this post! If you have not yet: please check out the other Podcast of the Week blog posts: link. This blog post is about market efficiency. What is the efficient market hypothesis, how does it work and what misconceptions are there about it. In this post we will explore these questions.

Table of Contents

Introduction

I think market efficiency is an important subject to understand for every investor, because it explains how the market reacts to new information. In combination with the model of market equilibrium (how assets are priced) the models define the expected return based on portfolio characteristics. The findings of groundbreaking empirical research done by Eugene Fama and Kenneth French are published in a variety of papers, their research is accelerated by the rise of computers, which enabled them to analyze large amounts of data and perform regression tests to draw insights. The logical conclusion is that picking individual stocks is futile. Further down in this post I will elaborate on this.

Adoption of market efficiency

Unfortunately this conclusion is not widely adopted, as we can see in an analysis done by Bloomberg; 54% of US domestic equity-fund market is passive, that means that the remaining 46% of the funds still actively pick stocks. The international market excluding the US is even further off, only 41.5% of the equity-fund market is passive (Seyffart, 2021). Of course this does not mean that all passive equity funds follow the models of Fama and French, it only says they adhere to rule based investing, opposed to counter productive stock picking.

Stock picking is counter productive, this is supported by Larry Swedroe, a big proponent of a passive approach. He is writing regular articles on passive versus active; on https://www.etf.com . Some highlights related to performance of individual stocks that he mentions:

In the period 1983 through 2006 the Russel 3000 index provided an 12.8% annualized return. The median return of these stocks was 5.1%.
39% of stocks lost money (even before inflation) during the period.
64% of stocks underperformed the Russell 3000 Index.
He mentions further research in his article, (Larry Swedroe, 2017).

I think it is fascinating but sad that a majority of the investors has not yet fully accepted the conclusions from academic research. I understand it is in the interest of active managers and brokers to keep this ignorance alive. In this article I hope to inform you about the efficient market, so you can avoid costly mistakes. By shining a light on the common misconceptions that exist about market efficiency.

Rational Reminder

The Rational reminder is a podcast by Ben Felix and Cameron Passmore. They discuss a variety of topics in an informal setting; Personal finance, investing, behavior and financial markets. The goal of the podcast is to make listeners, better and more rational investors. I think the podcast is great, they have academic guests like Larry Swedroe and Kenneth French. They make financial and behavioral research accessible by explaining the results in layman terms. Their work complements the advanced theories by making them understandable for a wider audience.

The podcast episode: Market Efficiency

Ben Felix

In relatable fashion Ben Felix runs his YouTube channel. This is how I discovered the Rational Reminder podcast. He makes videos on a variety of investment subjects and explains them with easy to understand visuals. Also the video footage of the Rational Reminder podcast is on his channel.

What is it

There are different definitions of the efficient market theory. The definition of Eugene Fama goes as follows: “A market in which prices always ” Fully Reflect” available information is called “Efficient” (Fama, 1970) The efficient market hypothesis is a simple concept but widely misunderstood. The cause for informational efficiency in the market is:

Competition for profits.
Low transaction costs.
Readily available information.

This means as soon as new information is released about future profits of a business, this will be picked up by traders and cause traders to buy or sell the asset. The effect of this is that prices change quickly with new information. New information is random therefore the stock prices are too, since they react quickly to reflect new information. Subsequently we can conclude that it is futile to pick individual stocks., picking stocks does not improve expected return.

How do we know that markets are efficient?

First we need to understand two definitions:

Empirical observations: Concrete data. Drawing insights from these observations is hard.
Theory: Is an idea why things work the way they do.

In financial economics empirical observations and theory are tied together by scientific method. Forming a hypothesis > collecting data > testing the hypothesis by analyzing the data. Paul Samuelson brought forward the idea in 1965 that we would expect prices to change as investors expectations adapt to new information. This theoretical explanation goes by the name; the fair game model. This model brought meaning to the randomness of stock prices. Following this in 1970; the ground breaking paper of Eugene Fama: Efficient Capital Markets: A review of Theory and Empirical Work (Fama, 1970). In summary: Fama formalized an empirical approach to testing the theory of market efficiency.

Fama never stated that the efficient market is reality. It is a theory, not meant to be reality. But reality looks very similar to what we would predict an efficient market to look like.

Prices should move randomly.
Active managers are not successful at beating the market.
Prices move quickly on new information.

What is the model of market equilibrium

The model of how the market prices assets. An example of a model of market equilibrium is the Capital Asset Pricing Model (CAPM), the model prices assets based on their risk relative to the market, measured by beta. But the model doesn’t explain why value stocks produce higher returns than would be expected based on their market riskiness. A conclusion which can be derived from this is; this is a violation of the efficient market hypothesis. The excess return cannot be explained by risk.

Later studies found that the model for market equilibrium didn’t account for independent risk of value stocks, this means the efficient market theory was not violated. Value stocks were just riskier than we originally understood. This is the biggest challenge of the efficient market theory: It cannot be definitively proved or disproved. Eugene Fama acknowledges this as the joint hypothesis theorem. “Any attempt to test market efficiency is really a test of two distinct hypotheses: A test of the efficient market hypothesis and a test of the model of market equilibrium.”

The limitations of the CAPM were one of the reasons for Fama to do further research, the research lead to the three factor model (1992). Further research developed two additional factors, this resulted in the five factor model in 2014. Which consists of the following factors:

Market risk: The relative risk to the market, measured by Beta.
Size: Small cap stocks outperform growth stocks.
Value: Low price relative to book value.
Profitability: Higher operating profitability.
Investment: Stocks of companies with high total asset growth have below average returns.

The efficient market hypothesis created a framework for empirical finance to rely upon. To allow economists to evaluate theories by their predictions. However, without this empirical finance would be a collection of anecdotes, which means a sample without theoretical explanation or empirical corroboration.

Key takeaways

The key takeaways of the podcast episode about market efficiency.

1. Anecdotal misconceptions

The efficient market hypothesis is dismissed by a lot of people for the wrong reasons. They provide anecdotal evidence against the theory by pointing at perceived market mispricing or out-performance by individuals. They do so by providing anecdotal ” What about” statements. One common example is the out-performance of Warren Buffett, he outperformed the S&P500 index between 1965-2020 with a nearly 10% annual gain. As stated in his annual shareholder letter of 2020 (Source). In the podcast episode the following reactions are given on his performance:

Luck in combination with a high concentration.
Systematic investment strategy with a strong value tilt.
The use of leverage, betting against beta; the market risk factor.
Did not beat the market for long periods, under-performed the US market from 2002 to 2021 year end of. Mainly because of scale problems.

For me the fact that only a handful of people have consistently (20+ years) outperformed the US market underlines the importance of research to explain returns. If you want to learn more about the story of Warren Buffett and Berkshire Hathaway, I recommend listening to the Acquired podcast that made a three part series on their history: https://www.acquired.fm/episodes/berkshire-hathaway-part-i. I think there is a lot we can learn from Warren Buffett, not only from his investment strategy but also his philosophy of staying invested and to focus on the long-term.

The momentum factor predicts that stocks that have performed well in the recent past will continue to outperform. It is hard to capture this factor, it has a high turnover because it is based on stock returns of between 2 and 12 months ago. It can be hard to follow this as a strategy because it needs to be revised on a monthly basis, this will cause transaction costs which can erode real returns. An alternative is to not pursue this factor on it’s own, but as a complementary strategy.

3. The market isn’t perfectly efficient

The efficient market theory doesn’t mean that prices are always right.
When new information becomes public the price of an asset will over or under adjust. This means prices can be wrong in the short term, this is according to the random walk theory (more information about the random walk theory: https://www.investopedia.com/terms/r/randomwalktheory.asp ) Market prices are unbiased, skewness will exist.

4. Market efficiency has forms

Fama says the market isn’t perfectly efficient, this means that mispricing can exist and that this is exploitable. It is simply unlikely to find the mispriced stocks. He argues that the market is informational efficient. He defined three levels of market efficiency:

Weak form: Past information is in prices.
Semi strong form: Public information is in prices.
Strong form: There are no traders that have an informational advantage.

Market efficiency is related to every phase of Know Act Invest. The efficient market theory is a comprehensive framework to support a passive approach to investing. It can help you explain returns (Know), Adjust your strategy based on the model for market equilibrium (Act) and invest your money based on empirical research opposed to anecdotal stories.

References

Eugene F. Fama and Kenneth R. French, 2006, Profitability, investment and average returns, accessed 23 January 2022, https://www.sciencedirect.com/science/article/abs/pii/S0304405X06001164

Eugene F. Fama, 1970, Efficient Capital Markets: A review of Theory and Empirical Work, accessed 31 January 2022, https://www.jstor.org/stable/2325486?seq=1#metadata_info_tab_contents

Eugene F. Fama and Kenneth R. French, 2014, A five-factor asset pricing model, accessed 31 January 2022, https://www.sciencedirect.com/science/article/abs/pii/S0304405X14002323

James Seyfffart, 2021, Passive likely overtakes active by 2026, earlier if bear market, accessed 6 February 2022, https://www.bloomberg.com/professional/blog/passive-likely-overtakes-active-by-2026-earlier-if-bear-market/

Larry Swedroe, 2017, Swedroe: Perils Of Owning Individual Stocks, accessed 6 february 2022, https://www.etf.com/sections/index-investor-corner/swedroe-perils-owning-individual-stocks?nopaging=1