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8/13/2019 EMH - Ch6 - Revised Lecture
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A lpha, the Cap ital Markets, and
the Effic ien t Markets Hypothes is
(Chapter 6)
Adapted from Portfolio Construction, Management, & Protection , 4e, Robert A. Strong
Copyright 2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.
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No matter how many winners youve got, if you
either leverage too much or do anything that
gives you the chance of having a zero inthere, itll all turn into pumpkins and mice.
Warren Buffett
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Outline
Introduction
Alpha and Portfolio Management
Role of the Capital Markets
Efficient Market Hypothesis
Anomalies
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What is alpha?
Alpha = the amount by which the market is beaten, afteradjusting for risk
What is alpha for the market as a whole?
Alpha for market as a whole is zero
So, on average, portfolios are ON the SML
Provides conceptual value of CAPM
Regardless of whether market is efficient, it is still a zero-sumgame
Burden of active manager In order to win (i.e., beat the market), someone else has to lose
Key question = what is special about you (and aboutyour knowledge) that will allow you to be the one thatwins?
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Generating alpha
Are there ways to consistently generate
alpha?
See portfolio manager performanceexample:
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Portfolio Managers Performance:
Past Three Years
Previous Three Years: S&P 500
Fund
Manager
Compound Annual Return -4.98% -22.01%
Total Return -14.20% -52.56%
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Portfolio Managers Performance:
Past Four Years
Previous Four Years: S&P 500
Fund
Manager
Compound Annual Return 0.50% -14.19%
Total Return 2.02% -45.77%
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Portfolio Managers Performance:
Past Five Years
Previous Five Years: S&P 500
Fund
Manager
Compound Annual Return 3.17% -0.54%
Total Return 16.91% -2.67%
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Portfolio Managers Performance:
Past Six Years
Previous Six Years: S&P 500
Fund
Manager
No. of Down Years 2 of 6 4 of 6
Compound Annual Return 3.29% -1.66%
Total Return 21.47% -9.58%
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Generating alpha
Would you have invested with this manager?
Who is this manager with this horrible record?
Warren Buffett, of course!!! Portfolio = investment in Berkshire-Hathaway, over
the period of 19701975
Note: while stock price lagged marketsubstantially, book value per share grew fasterthan market each year except 1975; this is ametric with which Buffett is more concerned
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Generating alpha
As we have seen previously in discussing the EMH, valuestocks tend to outperform growth stocks
Concomitantly, Warren Buffett has the best investment
record in history, becoming the 2nd
richest man in the worldin the process
However, as we have just now seen, although value winson average, over the long run, it does notwin perfectlyconsistently!
Instead, the markets tend to cycle, with different styles ofinvestment performing well at different times
B k M k P di f R
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Book to Market as a Predictor of Return:Value (positive a) tends to outperform Growth (negative a)
Value
0%
5%
10%
15%
20%
25%
Annualized
Rate
ofReturn
10987654321
High Book/Market Low Book/Market
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Rolling Annualized Average 5-year Difference
Between the Returns to Value and Growth Composites:The Market cycles between Value and Growth,
But Value Wins on Average
-20%
-10%
0%
10%
20%
30%
40%
50%
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
199
2
199
3
199
4
199
5
199
6
1997
Year
Relative
Difference
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Empirical Regularities:
Sources of alpha Three categories that tend to outperform over the long run:
Valuestocks vs. Growth stocks
Size: Small caps tend to outperform large caps
Momentum: stocks with momentum (earnings or price) tend to beatstocks without momentum
However, the payoffs to all of these tend to cycle!
A typical portfolio manager, being judged on a quarter-by-quarterbasis, would have been fired long before if he had the same record
as Buffett for 19701975!
(In fact, he fired himself during this period!)
None of these beats the market perfectly consistently
A typical portfolio manager would need to try to cycle along with the
market, in order to keep from ever lagging too far behind it
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Empirical Regularities:
Sources of alpha Beating the market consistently would require some sort of
rotation strategy in order to profit from the type of securitiesthat are performing well in the given type of market
But - combination of fat tails and volatility clustering
(discussed previously) can cause problems! Best performance for a given style is likely to follow closely on the
heels of its worst performance, and much of the movement for thestyle is likely to come in a relatively short burst (thus, if you miss it,its gone)
E.g.: 40% of the stock market gains for the entire decade of the1980s occurred during a mere 10 trading days !
So efforts to cycle with the market and keep from falling too farbehind it also make it much more difficult to beat the market!
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Capital Market Theory
Capital market theory springs from the
notion that:
People like return
People do not like risk
Dispersion around expected return is a
reasonable measure of risk
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Role of the Capital Markets
Definition
Economic Function
Continuous Pricing Function
Fair Price Function
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Definition
Capital markets trade securities with lives ofmore than one year
Examples of capital markets New York Stock Exchange (NYSE)
American Stock Exchange (AMEX)
Chicago Board of Trade
Chicago Board Options Exchange (CBOE)
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Economic Function
The economic functionof capital markets
facilitates the transfer of money from savers
to borrowers
e.g., mortgages, Treasury bonds, corporate
stocks and bonds
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Continuous Pricing Function
The continuous pricing functionof capital
markets means prices are available moment
by moment
Continuous prices are an advantage to
investors
Investors are less confident in their ability to geta quick quotation for securities that do not trade
often
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Fair Price Function
The fai r pr ice fun ct ionof capital marketsmeans that an investor can trust thefinancial system
The function removes the fear of buying orselling at an unreasonable price
The more participants and the more formal themarketplace, the greater the likelihood that thebuyer is getting a fair price
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Efficient Market Hypothesis
Definition
Types of Efficiency
Forms of Efficiency
Weak Form
Semi-Strong Form
Strong Form
Semi-Efficient Market Hypothesis Security Prices and Random Walks
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Definition
The efficient market hypothesis (EMH)is the
theory supporting the notion that market prices are
in fact fair
Under the EMH, security prices fully and fairly (i.e.,without bias) reflect all available information about the
security
Since the 1960s, the EMH has been perhaps the most
important paradigm in finance Whether markets are efficient has been extensively
researched and remains controversial
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Types of Efficiency
Operational efficiencymeasures how well
things function in terms of speed of
execution and accuracy
It is a function of the number of orders that are
lost or filled incorrectly
It is a function of the elapsed time between the
receipt of an order and its execution
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Types of Efficiency (contd)
Informational efficiencyis a measure ofhow quickly and accurately the marketreacts to new information
This is the type of efficiency with which the EMHis concerned
The market is informationally very efficient Security prices adjust rapidly and fairly accurately to
new information However, as weve already seen, the market is still
not completely efficient
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Forms of Market Efficiency
Eugene Famas original formulation of the EfficientMarket Hypothesis established three forms of marketefficiency, based on the level of information reflected insecurity prices:
1. Weak form= prices reflect all past market level (priceand volume) information
2. Semi-strong form= prices alsoreflect all publiclyavailable fundamental company and economic
information3. Strong form= prices alsoreflect all privately held
information that would affect the value of the companyand its securities
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Weak Form
Definition
Charting
Runs Test
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Definition
The weak formof the EMH states that it is
impossible to predict future stock prices by
analyzing prices from the past
The current price is a fair one that considers
any information contained in the past price data
Charting techniques are of no use in predictingstock prices
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Definition (contd)
Example
Which stock is a better buy?
Stock A
Stock B
Current Stock Price
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Definition (contd)
Example (contd)
Solution: According to the weak form of the EMH, neither
stock is a better buy, since the current price alreadyreflects all past information.
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Charting
People who study charts are technical
analystsor chartists
Chartists look for patterns in a sequence ofstock prices
Many chartists have a behavioral element
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Runs Test
A runs testis a nonparametric statisticaltechnique to test the likelihood that a series ofprice movements occurred by chance
A runis an uninterrupted sequence of the sameobservation
A runs test calculates the number of ways an observednumber of runs could occur given the relative number of
different observations and the probability of this number
These tests have provided evidence in favor of weakform efficiency
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Conducting A Runs Test
1 2
1 2
1 2 1 2 1 2
21 2 1 2
1 2
where number of runs
21
2 (2 )
( 1)
, number of observations in each category
standard normal variable
R xZ
R
n nx
n n
n n n n n n
n n n n
n n
Z
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Semi-Strong Form
The semi-strong formof the EMH states that
security prices fully reflect all publicly
available information
e.g., past stock prices, economic reports,
brokerage firm recommendations, investment
advisory letters, etc.
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Semi-Strong Form (contd)
Academic research supports the semi-strong form of the EMH by investigatingvarious corporate announcements, such as:
Stock splits Cash dividends
Stock dividends
Examined through event studies This means investors are seldom going to
beat the market by analyzing public news
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Market seems to do a relatively good job at adjusting astocks valuation for certain types of new information
Determining how much the new info. will change the stocks valueand then adjusting the price by an equivalent amount
This is what event studies examine
But it does seem to have problems developing an overallvaluation for a stock in the first place
E.g., What is the correct value for IBM as a whole is a very difficultquestion to answer, but how much IBMs value should change if it isawarded a specific new contract is much easier to determine
Semi-Strong Form (contd)
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Semi-Strong Form (contd)
Burton Malkiel points out that two-thirds ofprofessionally managed portfolios are consistentlybeaten by a low-cost index fund
Suggests that securities are accurately priced and thatin the long run returns will be consistent with the level ofsystematic risk taken
Supports semi-strong form of the EMH
Also would suggest that portfolio managers do not
possess any private information that is not alreadyreflected in security prices
Supports the strong form of the EMH
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Strong Form
The strong formof the EMH states thatsecurity prices fully reflect all relevant publicand private information
This would mean even corporate insiderscannot make abnormal profits by usinginside informationabout their company
Inside informationis information not availableto the general public
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Semi-Efficient
Market Hypothesis The semi-efficient market hypothesis (SEMH)
states that the market prices some stocks moreefficiently than others
Less well-known companies are less efficiently priced
The market may be tiered
A security pecking order may exist
Lynch prefers stocks that the analysts dont follow
and the institutions dont own
See the Small Firm and Neglected Firm Effectsdiscussed later
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Security Prices and
Random Walks
The unexpected portion of news follows a
random walk
News arrives randomly and security pricesadjust to the arrival of the news
We cannot forecast specifics of the news very
accurately
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Anomalies
Definition
Low PE Effect
Low-Priced Stocks
Small Firm and Neglected Firm Effect
Market Overreaction
Value Line Enigma
January Effect
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Anomalies (contd)
Day-of-the-Week Effect
Turn-of-the Calendar Effect
Persistence of Technical Analysis
Behavioral Finance
Joint Hypothesis Problem
Chaos Theory
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Definition
A financial anomalyrefers to unexplained
results that deviate from those expected
under finance theory
Especially those related to the efficient market
hypothesis
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Low PE Effect
Stocks with low PE ratios provide higher returnsthan stocks with higher PEs
And similarly for high P/B (hence lower Book/Market)stocks
Supported by several academic studies
Conflicts directly with the CAPM, since studyreturns were risk-adjusted (Basu)
Related to both semi-strong form and weak formefficiency
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Low-Priced Stocks
Stocks with a low stock price earn higher
returns than stocks with a high stock price
There is an optimum trading range
S ll Fi d N l t d Fi
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Small Firm and Neglected Firm
Effects
Small Firm Effect
Neglected Firm Effect
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Small Firm Effect
Investing in firms with low marketcapitalization will provide superior risk-adjusted returns
Supported by academic studies
Implies that portfolio managers should give
small firms particular attention
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Neglected Firm Effect
Security analysts do not pay as much
attention to firms that are unlikely portfolio
candidates
Implies that neglected firms may offer
superior risk-adjusted returns
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Market Overreaction
The tendency for the market to overreact toextreme news
Investors may be able to predict systematicprice reversals
Results because people often rely tooheavily on recent data at the expense of the
more extensive set of prior data
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The Value Line Enigma
Value Line (VL) publishes financial information onabout 1,700 stocks
The report includes a timing rank from 1 down to 5
Firms ranked 1 substantially outperform themarket
Firms ranked 5 substantially underperform the
market
Victor Niederhoffer refers to Value Lines ratingsas the periodic table of investing
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The Value Line Enigma
Changes in rankings result in a fast priceadjustment
Some contend that the Value Line effect is merely
the unexpected earnings anomaly due to changesin rankings from unexpected earnings
Nonetheless, Value Lines successful record is
evidence in support of the existence of superioranalysts who apparently possess privateinformation
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January Effect (contd)
Possible explanations:
Tax-loss trading late in December (Branch)
The risk of small stocks is higher early in theyear (Rogalski and Tinic)
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January Returns by Type of Firm
7.71%10.72%11.32%Neglected
Non-S&P 500
Companies
5.03%6.87%7.62%Neglected
1.69%4.19%4.95%Moderately
Researched
-1.44%1.63%2.48%Highly
Researched
S&P 500
Companies
Average January
return after
adjust ing for
systematic r isk
Average January
return m inus average
monthly return in rest
of year
Average
January
return
Source: Avner Arbel, Generic Stocks: The Key to Market Anomalies, Journal of Portfolio Management, Summer 1985, 413.
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Day-of-the-Week Effect
Mondays are historically bad days for the
stock market
Wednesday and Fridays are consistentlygood
Tuesdays and Thursdays are a mixed bag
D f th W k
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Day-of-the-Week
Effect (contd) Should not occur in an efficient market
Once a profitable trading opportunity isidentified, it should disappear
The day-of-the-week effectcontinues topersist
Howeverthere are confounding effectsbetween the levels and the volatilities ofreturns across different days
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Persistence of
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Persistence of
Technical Analysis Technical analysisrefers to any technique in
which past security prices or other publiclyavailable information are employed to
predict future prices Studies show the markets are efficient in the
weak form
Literature based on technical techniquescontinues to appear but should be useless
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Behavioral Finance
Concerned with the analysis of variouspsychological traits of individuals and how thesetraits affect the manner in which they act asinvestors, analysts, and portfolio managers
Growth companies will usually not be growthstocks due to the overconf idenceof analystsregarding future growth rates and valuations
Notion of herd m ental ity of analysts in stockrecommendations or quarterly earnings estimatesis confirmed
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Chaos Theory
Chaos theoryrefers to instances in whichapparently random behavior is systematic or evendeterministic under Mauboussins theory of the market as a complex
adaptive system, then we would expect to see chaoticdynamics
Econophys icsrefers to the application of physicsprinciples in the analysis of stock market behavior
e.g., an investment strategy based on studies ofturbulence in wind tunnels
Includes use of multifractal models
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Are Markets Rational?
This question always faces ajo in t hypo thes is
problem:
Tests of EMH are always dualtests of bothmarket
efficiency and the specific asset-pricing model assumed
Market efficiency
Is the stocks price equal to its true value?
Asset pricing model used (CAPM, APT, etc.)
What isthe stocks t ruevalue?
Never known for sure
The question of value presupposes an answer to the question,
of value to whom, and for what? Ayn Rand
E.g., the value of Apple stock would be different to Steve Jobs
than to any other investor
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Are Markets Rational?
Related issuewhat is information? Information is that which causes changes Claude
Shannon (father of information theory)
So, if something causes the markets to move, then by
definition, it must be information, and vice versa
From this perspective, the market is neither efficient nor
inefficient, it just is
So, are the markets efficient or rational?
Ultimately, difficult to answer categorically
Key question is not whether or not the markets are efficient
this is a side issuebut how investors should act, given
how the markets work
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