Sample Essay on Efficiency

A famous financial economist named Eugene Fama conducted the first major, comprehensive examination of the market efficiency question. He recognized that there may be degrees of market efficiency ranging between a market that is not efficient to one that is perfectly efficient. To test just how efficient the market is, he looked first at whether the markets were even slightly efficient. He called this level of efficiency weak form market efficiency.

If the markets were weak form efficient then all historical information would be reflected in stock prices. Put another way, no unusually high earnings would be possible by using historical information, such as past prices, old news articles, or last month’s annual report. Fama deemed this the weakest test of market efficiency since historical information is readily available to everyone nearly costlessly. If an investor could profit from using this type of information, the markets could not really be very efficient at all.

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After studying the results of dozens of research projects, Fama was unable to find any evidence that superior returns could be earned by using historical information. This rejected the entire field of technical analysis, which refers to investing based on studying the patterns of past prices. For example, a technical analyst may load a high speed computer with all of the stock returns for the last 60 years and program it to search for any patterns that repeat themselves. Say if two up-ticks followed by three down-ticks is usually followed by an up-tick, then a trading rule is established. The computer is then programmed to search current stock returns for the pattern and to issue a buy order whenever the pattern is located. Even using the most sophisticated programs and most complicated data searches, Fama could uncover no convincing evidence of profits. He then proclaimed that the markets were at least weak form efficient.

Fama next examined whether any public information could be used to earn superior returns. If no unusual profits could be earned using public information, the markets would be semi-strong form efficient. Fama reviewed studies looking at the impact of earnings announcements, stock splits, and other events for evidence that stock prices quickly adjusted to their news content. He concluded that investors could not earn usual returns by trading on public information. This supported the idea that the markets are at least semi-strong form efficient.

In a strong form efficient market all information, both public and private, is reflected in the price of the stock. In Fama’s original research, he examined strong form market efficiency by looking at the performance of mutual funds. He hypothesized that mutual fund managers should have access to insiders who would provide them with inside, nonpublic information. Many studies have been conducted attempting to show whether these managers are able to earn superior returns. To date, there is no convincing evidence that fund managers are able to outperform a random selection of stocks over the long run. A well-respected researcher named Michael Jensen looked at mutual fund performance. Jensen evaluated the risk and return of mutual funds and plotted them on the security market line. He
found that more of them were below the line than above. This indicates that investing in a mutual fund results in about a 1% lower return than would be earned with a random pick of stocks. Later in this same research paper Jensen demonstrated that the negative returns are approximately equal to the cost of staff salaries, office space, advertising, data acquisition, and commissions that mutual fund managers must pay. Thus, the source of the underperformance is the expenditure of funds associated with the management of the funds.

Most people do not consider this as supporting strong form market efficiency, since there is no proof that fund managers actually have insider information. Instead, the failure of fund managers to earn better returns than a random draw of stocks is viewed as additional support for semi-strong form efficiency.

The Wall Street Journal has been running a contest for years where mutual fund managers are challenged to pick stocks that perform better than those selected by The Wall Street Journal staff who throw darts at the stock page of the Journal. So far the pros are ahead of the darts, but not by much.

For the market to be strong form efficient, no superior earnings would be possible, even with inside information. In fact there is a great deal of evidence that tremendous profits are possible when insider information is used. Despite insider trading being against the law and the severe penalties imposed for infractions, the profits frequently prove too tempting to pass up. In one of the most famous insider trading scandals, Ivan Boesky, a fund manager, conspired with Michael Milkin, an investment banker with Drexel Lambert Securities, to earn millions of dollars in insider trading profits. With this in mind we can safely reject strong form market efficiency.

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