Testing market's efficiency

GUEST COLUMN/ TORCH-LIGHT

Last fortnight we had commenced a discussion on the efficiency of the efficient market hypothesis (EMH). Having comprehended this rather abstract hypothesis, let us see how it stands an empirical test in flesh and blood scenarios.

If the markets are really efficient, the serious question for investment professionals is what role they can play (and be compensated for).

Those who accept EMH reason that the primary role of a portfolio manager consists of analysing and investing based on the investor's tax considerations and risk profile.

Optimal portfolios will vary according to factors such as age, tax bracket, risk aversion and employment. The role of the portfolio manager in an efficient market is to tailor a portfolio to those needs, rather than to beat the market.

While proponents of EMH do not believe it is possible to beat the market, some believe that stocks can be divided into categories based on risk factors (and corresponding higher or lower expected returns).

For instance, some believe that small stocks are riskier and, therefore, are expected to have higher returns. Appropriate benchmarks, therefore, refer to comparable securities of similar characteristics. In other words, it's important to compare apples with apples and oranges with oranges.

For instance, the performance of a small-stock fund can be compared to that of an index of small stocks while a growth-stock fund is best compared to a growth-stock index.

However, faced with the inference that they cannot add value, many active managers argue that markets are not efficient (otherwise their jobs can be viewed as nothing more than speculation).

Similarly, the investment media is generally considered to be ambivalent toward EMH because it makes money supplying information to investors who believe that the information has value (beyond the time when it becomes public).

If the information is rapidly reflected in prices, there is no reason for investors to seek (or purchase) information about securities and markets.

While many argue that out-performance by one or more participants in a market signifies an inefficient market, it's important to recognise that successful active managers should be evaluated in the context of all participants.

It is difficult in many cases to determine whether out-performance can be attributed to skill as opposed to luck. The challenge is to identify an out-performer well in advance.

Additionally, in many cases, strong performers in one period frequently turn around and under-perform in subsequent periods.

A substantial number of studies has found little or no correlation between strong performers from one period to the next. The lack of consistent performance among active managers is an evidence in support of EMH.

The paradox of efficient markets is that if every investor believes a market is efficient, the market will not be efficient because no one will analyse securities. In effect, efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to out-perform the market.

In reality, markets are neither perfectly efficient nor completely inefficient. All markets are efficient to a certain extent, some more so than others. Market efficiency is more a matter of shades of gray.

In markets with substantial impairments of efficiency, more knowledgeable investors can strive to out-perform less knowledgeable ones. Government bond markets, for instance, are considered to be extremely efficient.

Most researchers consider large-cap stocks also to be very efficient, while small-cap stocks are considered by some to be less efficient.

Real estate and venture capital - which don't have fluid and continuous markets - are considered to be less efficient because different participants may have varying amounts and quality of information.

The efficient market debate plays an important role in the distinction between active and passive investing. Passive investing involves purchasing diversified portfolios of all the securities in an asset class.

Active investing involves over-weighting securities and sectors within an asset class believed to be undervalued and under-weighting securities and sectors believed to be overvalued. Active managers argue that less-efficient markets provide an opportunity for out-performance by skillful managers.

However, it is important to realise that a majority of active managers in a given market will under-perform the appropriate benchmark in the long run whether markets are efficient or not.

This is because active management is a zero-sum game in which the only way a participant can profit is for another less fortunate active participant to lose. However, when costs are added, even marginally successful active managers may under-perform.

Some believe a third view of market efficiency, which holds that the securities market will not always be either quick or accurate in processing new information.

On the other hand, it is not easy to transform the resulting opportunities to trade profitably against the market consensus into superior portfolio performance.

Why aren't more active investors consistently successful? The answer lies in the cost of trading. Therefore, the decision to pursue an active or passive trading strategy depends on your opinion about market efficiency.

While the theory remains disputed, it is necessary for one to have confabulated over the same at some point of time. And given the kind of confused market scenario we find ourselves in, it is high time we discussed EMH.

(The author heads Lotus Knowlwealth, Mumbai, and can be contacted at ceolotus@hotmail.com.)