What Is The Efficient Market Hypothesis

Efficient Market Hypothesis (EMH)

The efficient-market hypothesis (EMH) is a financial economics theory that asset prices fully reflect all available information. In the EMH, prices change to remember information that comes to light almost instantaneously, and there is no way to "beat the market" consistently on a risk-adjusted basis.

The theory was developed by economist Eugene Fama in the late 1960s and has since become one of the most influential and extensively studied theories in finance. This article will examine the theory that may provide light on profitable investment strategies.

What is the Efficient Market Hypothesis?

EMH, also called efficient market theory, holds that all available information is already reflected in stock prices and, therefore, cannot be consistent gains. As a result of this hypothesis, no trader, investor, or fund manager would be able to generate returns higher than the market average. This is because there would be no overpriced or undervalued stocks.

For instance, shocking news often results in a surprising reaction. Since EHM claims that all traders react the same way to new information, no investor can gain a competitive advantage, and regular market operation will resume.

Fundamental and technical analysis are rendered irrelevant regarding EHM since no information can lead to outsized profits except insider trading. That's why EMH is so problematic and disputed. It has a lot of fans, but plenty of critics, too. 

A vital drawback of the EMH is that it cannot explain the movement of stock prices as other financial theories do.

What are the types of EHM?

Believers of the efficient market hypothesis most commonly prefer passive investing methods that closely track benchmark performance. The theory can be categorized into 3 forms:

1. The Weak Form of the EMH

According to the EHM, stock prices accurately reflect all relevant market information. However, the efficient market hypothesis is a weak form of the belief that holds that prices may not accurately reflect information that has not yet been published.

In addition, it assumes that pricing will be determined solely by new details rather than historical data, so technical analysis (TA) is meaningless.

Fundamental analysts who intuitively understand how forthcoming information affects stock prices can beat the market in the short term using the weak version of the efficient market hypothesis.

2. The Semi-Strong Form of the EMH

Similar to the weak form, this form relies on the same premises as the weak form, with the additional assumption that new information is reflected immediately in stock prices. Technical analysis or fundamental analysis cannot generate excess profits due to this.

3. The Strong Form of the EMH

According to supporters of the strong variant of the efficient market hypothesis, the current security price already accounts for all available information, whether that information is public or not. As a result, investors won't be able to profit from a sudden increase in stock prices, even if they have access to confidential information.

Arguments For and Against the Efficient Market Hypothesis

This is why efficient market theorists often favor passive investment vehicles such as index funds and exchange-traded funds (ETFs) that track benchmark indexes. 

Since investors use a wide range of approaches, it's evident that not everyone accepts the efficient market theory only.

Many Investors, mutual funds, and other funds use active management to exceed a benchmark index, and this strategy has helped these funds become pretty popular in the financial world. Buffett is a strong opponent of the passive technique when it comes to investment since he does not trust the EMH.

The Case for Active Investing

Investment professionals, known as "active portfolio managers," claim that their team of analysts and expertise can enable them to outperform the market benchmark by exploiting market inefficiencies.

Both viewpoints can indeed be supported by evidence. Morningstar releases the Active vs. Passive Barometer every six months, comparing active managers and their passive counterparts.

In 2021, only 45% of actively managed funds outperformed passively managed funds, according to a study of almost 4,000 funds.

In contrast, Morningstar reported that only 26% of active funds outperformed passive funds over the 10 years ending December 2021. In India, on the other hand, Active management has consistently outperformed the benchmark. A summary of the data is provided below:

Source: Data- Economic Times.

In 2021, more than 60% of active equity schemes outperformed their respective benchmarks in India's mutual fund industry.

The growing interest in passive investment vehicles like mutual funds and exchange-traded funds is sometimes cited as proof that EMH retains some supporters. Active funds should outperform their passive counterparts if EMH is flawed and markets are inefficient, but this is rarely the case.

The efficient market hypothesis implies that passive investing is often more efficient than active investing in many cases.  

EMH and Investing Strategies

EMH supporters, even those who believe in the theory's weak form, frequently invest in index funds and exchange-traded funds (ETFs). Due to their passive management, these funds merely replicate the performance of the market rather than attempt to improve upon it.

Although many believe that stock prices can be predicted at least partially, they still attempt to beat the market. The efficient market hypothesis (EMH) is incompatible with day trading. A trader looks for patterns and trends that can be observed over a short period. Then they use these patterns to predict when to purchase or sell. Intraday traders are unlikely to agree with the strong EMH.

Are Some Markets Less Efficient than Others?

According to the Morningstar study, active vs. passive management results differ greatly depending on the fund type.

The average return of active managers on U.S. real estate funds is 62.5%, but a cost-adjusted return is only 25%.

High-yield bond funds and diversified emerging market funds at 59.5% and 58.3%, respectively, are other sectors where active management often outperforms passive before costs. Actively managed portfolios often underperform passive ones because of their extra expenses. 

Passive managers have historically beaten their active counterparts in almost every asset class. In the U.S. large-cap mix, active managers outperformed passive managers 17.2% of the time, falling to just 4.1% once costs were considered.

Indian active management, on the other hand, has consistently outperformed the index. According to research conducted over the last decade, the Indian market has tremendous potential for creating alpha than any other mature or growing market. 

Based on an analysis of all countries from 2009-2018, the average active manager in India achieved the greatest annualized excess return of 3%.

India's unique mid- and small-cap sectors contribute to the market's alpha-producing potential. India stands apart from other developing and mature markets in that each industry has small- and mid-cap categories.

These findings indicate that not all markets function as efficiently as others. For instance, liquidity and transparency may be problematic in developing markets.

Legal complications and the absence of investor safeguards may add to the already elevated political and economic insecurity levels. A skilled portfolio manager may exploit inefficiencies caused by these elements.

However, information is quickly reflected in stock prices in the U.S. markets for large-cap or mid-cap businesses. Even though this is a very efficient market, Morningstar data indicates that active managers have a far lower advantage over passive managers.

How Star Managers Handle Their Portfolios

Among the most successful investors on earth is Warren Buffett, who has studied Benjamin Graham, the father of fundamental analysis, for decades and has managed billions of dollars for clients. Buffett has been investing forever and has been a value investor all his life. Berkshire Hathaway, the holding company where he has placed his money for 56 years, has shown a 20.1% annual return. This beats the S&P 500, demonstrating a 10.5% yearly return.

From 1977 to 1990, Lynch managed Fidelity's Magellan Fund for a decade. Lynch's aggressive investment philosophy led to an annualized return of 29% and an 11-time outperformance of the S&P 500 for the fund.

In contrast, Jack Bogle, the founder of Vanguard and often referred to as the "father of indexing," is another illustrious figure in the financial industry. In his view, investment managers will not be able to beat the market over the long run because of the high costs they incur. Following his convictions about passive management, he launched Vanguard's first index fund in 1976.

Conclusion

Stock market forecasts are not always accurate, so the EMH is often supported by those who do not trust them. Even though you will not outperform the market continuously, you will do no better than the market average in the long run. Stock market fluctuations are random, so a long-term buy-and-hold strategy is best for most investors.

EMH's suggestions could be viewed skeptically by short-term traders who believe they can predict future stock prices accurately. Proponents of this theory state that it explains why so few money managers can provide superior returns relative to crucial market indices. The theory is criticized for not using active funding to exceed benchmark indices.