FINANCE 361 – Topic 9 – Market Efficiency

Paul Geertsema

1
Contents

1 Readings 3

2 What are we doing today 4

3 What is market efficiency? 5

4 In the beginning there was the random walk 8

5 The Efficient Market Hypothesis (EMH) 10

6 Inefficient markets ̸= easy money 13

7 Active vs passive investments 16

2 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
1 Readings

• Read BKM Ch 11

3 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
2 What are we doing today

• A discussion around market efficiency

4 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
3 What is market efficiency?

• An efficient market is one that reflects all available information

– https://en.wikipedia.org/wiki/Efficient-market_hypothesis
• That sounds reasonable enough...
• But on closer examination, things fall apart
– What exactly is this “all available information”? These days
there are a LOT of information.
◦ How do we decide whether information is relevant?
◦ Current sun-spot activity - probably not relevant to financial
market returns
◦ Or is it? Extreme sun-spot activity can be a precursor to
“electrical storms” that can cause blackouts - which surely
will impact financial markets
◦ What about all those high energy particle accelerators that
spit out gigabytes of data every second
5 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 What is market efficiency? (cont.)

– What would a market that reflects all available information even

look like (this is potentially counter-factual )?
◦ In other words, to determine if a market is inefficient, one
must compare it to a model of an efficient market
◦ But we have little idea what that is (a long time ago, aca-
demics thought the CAPM or Fama/French 3-factor model
could serve as a benchmark for an efficient market, but not
these days)

6 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 What is market efficiency? (cont.)

– A persuasive argument states that profitable inefficiencies will be

arbitraged away, so the market is efficient almost by definition.
◦ However, looking for efficiency is costly, so in equilibrium
there has to some level of inefficiency in order to make it
worthwhile for investors to search for efficiencies. Thus the
more relevant question is not whether markets are efficient,
but how efficient they are.
◦ But we can’t even answer that – to measure inefficiency, we
must be able to specify what efficiency looks like, and as
noted above, we don’t know how to do that
◦ An that is before we consider all the hurdles to arbitrage...
• So on close examination, the whole concept of market efficiency
seems fraught with problems (but at least they are interesting prob-
lems!)
• Let’s take a closer look

7 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
4 In the beginning there was the random walk

• A French assistant stock broker, Jules Regnault, was the first to

anticipate the idea that stock prices follow a random walk in 1863.
– “the deviation of stock prices are directly proportional to the
square root of time”
– This is in fact a mathematical property of Brownian motion
(aka a Wiener process), a mathematical concept that is the
continuous time equivalent of a random walk
• In 1900, another Frenchman, Louis Bachelier, wrote a PhD thesis
titled “The theory of speculation” in which he stated what is now
known as Brownian motion in a mathematically precise way. He
argued stock prices should follow a random walk.
– To make a fine distinction, it is really the log of prices that
should follow a random walk. If prices follow random walks,
then they might become negative, which should not happen for
stock prices.
8 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 In the beginning there was the random walk (cont.)

• The random walk hypothesis is closely linked to the idea of efficient

markets, in that it is a consequence of a perfectly efficient market
• In a perfectly efficient market there is no way to predict stock
prices, since any predictability is already incorporated in current
prices. The only thing that can move prices is the unpredictable
component of news (e.g. earthquake in Tokyo, coup in Brazil, fraud
at Enron). It follow that price movements must be unpredictable.
Chaining unpredictable movements together gives rise to a random
walk.

9 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
5 The Efficient Market Hypothesis (EMH)

• Eugene Fama (of Fama/French fame) introduced the Efficient Mar-

ket Hypothesis (EMH) to academic finance in 1970, building on
earlier work by Bachelier, Mandelbrot and Samuelson. (Mandelbrot
also invented fractals ( ), for which he is probably more famous.)
• Much of the 70, 80 and 90’s saw pitched battles between those
academics that believed markets are efficient (Fama and friends)
and those that thought markets were inefficient (Andrei Shleifer –
author of “Inefficient Markets” – and friends).

10 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 The Efficient Market Hypothesis (EMH) (cont.)

• This matters, because it colours how evidence of return predictab-

ility is interpreted (we cover return predictability in a later topic)
– EMH true believers: Predictable returns must be due to differ-
ences in risk between assets (or changes in the risk of a single
asset risk over time). You can’t really exploit return predictabil-
ity, since all you are doing is getting a higher return for bearing
higher risk. It should not be strange if the return predictability
persists in the future, even after the discovery is made public.
– EMH sceptics: Predictable returns are due to systematic mis-
pricing by investors. The mispricing may be due to behavioural
biases or market frictions. Predictable returns are exploitable.
Once the predictability is public, it will become less profitable
(depending on how easy it is to exploit).
– Note: Predictable returns may also be imaginary, the result of
diligent data mining by thousands of researchers

11 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 The Efficient Market Hypothesis (EMH) (cont.)

• Over the last two decades, the accumulated evidence has tilted
against a naive interpretation of the EMH. In particular, the hun-
dreds of documented anomalies (trading strategies that make money,
at least in past data) is difficult to reconcile with a strict belief in
the EMH. Also, many anomalies stopped making much money after
they were published, consistent with the predictions of EMH scep-
tics – although this is also consistent with data mining.

12 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
6 Inefficient markets ̸= easy money

• Have a look at this argument (markets are efficient):

– In an efficient market, active managers won’t be able to outper-
form passive managers
– We observe: Active managers do not outperform passive man-
agers
– Therefore, markets are efficient
• Are you convinced by this argument?
• At least it is backed up by empirical observation...

13 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 Inefficient markets ̸= easy money (cont.)

• Here is another argument using the exact same logic (any four-
legged animal is a llama):
– If the animal is a llama, it will have four legs
– We observe: The animal has four legs
– Therefore, the animal is a llama
• This kind of non-logic was recognised as nonsense even in ancient
Greece
• The solution is to recognise that efficient markets imply equivalence
of active and passive strategies, but the reverse implication need
not hold.
• That is, it is possible that markets are inefficient AND for active
managers fail to outperform passive managers.

14 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 Inefficient markets ̸= easy money (cont.)

• For instance, limits to arbitrage can make it difficult or impossible

to exploit even “obvious” mispricing
– Did you short Gamestop at $300 in early 2021? Why not?
– How about Tesla?
• In any case, the “obvious” mispricing can easily turn out be some-
thing simpler - you made a mistake and it is actually not mispriced.
(Bitcoin?)

15 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
7 Active vs passive investments

• Passive investment means tracking some index or benchmark

– Important: you can NOT invest directly in an index
– Only in a fund that tracks the index
◦ Management fees
◦ Tracking error
◦ Entry/Exit fees, or bid/ask if exchange traded
– NYSE ticker “SPY” tracks the S&P 500
– Or, you can do a DIY tracker fund, that is hold the index con-
stituents yourself
◦ You will still have to trade to rebalance, reinvest dividends,
etc
◦ Unless you are very rich it is not worth the hassle

16 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 Active vs passive investments (cont.)

• Active investment means you are investing effort in order to beat

the benchmark
– You will want to beat the benchmark (you can earn the bench-
mark return (less costs) by simply investing passively in a tracker
fund)
– You will have to invest effort
– Or more typically, you will pay an active fund manager to invest
effort in trying to beat the market

17 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 Active vs passive investments (cont.)

• “Trying” is a telling description

– Unlike some other disciplines (tennis, plumbing, cooking, dentistry)
it seems that trying hard is not sufficient to guarantee a measure
of success at beating the market
– Perhaps you also need to be smart?
◦ Evidence that smart retail investors outperform the rest (Finnish
dataset)
– But the hedge funds and large real money funds can pay to get
the smartest people (and they do); it does not seem to help
(reliably)
– So, is it all a big con?

18 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 Active vs passive investments (cont.)

– Thought experiment
◦ World A: Lots of diligent fund managers
· Little inefficiency as a result
· Not much scope for out-performance
◦ World B: Very few people bother to beat the market (every-
body is tracking)
· There should be many and large inefficiencies (“incorrect”
pricing)
· With a little effort, one should be able to beat the market
easily

19 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 Active vs passive investments (cont.)

– Provocative thought 1: The fact that fund managers as a group

do not outperform the market can be interpreted as evidence
that collectively they are doing a good job at eliminating mis-
pricing
– Provocative thought 2: If the market is really so efficient, you
might as well own the benchmark via a low-cost tracker fund
(4bp per year for S&P500). Why pay for active management
that does not deliver?
◦ This has become almost standard advice to investors
◦ If enough investors believe it, we will move closer to World B
(and the standard advice would become flawed!)
◦ Where do you think we are now?

20 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 Active vs passive investments (cont.)

• How can fund managers and investment advisers add value, other
than by beating the market?
– Appropriate risk
– Diversification
– Take the blame!
– [Following apply to investment advisers only]
– Tax considerations
– Retirement planning
– Estate planning
– Bankruptcy protection
– Counselling

21 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema
 Active vs passive investments (cont.)

• Reality is that the bulk of short term investment performance is

mostly luck
• Thought experiments
– Coin flipping experiment
– Letters to 4096 hedge funds (212 = 4096)

22 FINANCE 361 Class Notes – University of Auckland – Copyright (C) Dr Paul Geertsema