Efficient Market Hypothesis

What is the Efficient Market Hypothesis (EMH)?

Initially introduced by Eugene Fama in 1970, the efficient market hypothesis is an investment concept in the modern financial theory that explores the relationship between asset prices and the availability of information. It argues that while short-term excess returns are possible, all available information is already priced in (i.e. reflected in the price of an asset) and therefore it is impossible for an investor to consistently outperform the market (as defined by a market index such as the S&P 500 or the MSCI World) over the long-term. The theory outlines three forms of market efficiency that are categorized depending on the level of information available.

How the Efficient Market Hypothesis (EMH) Work?

The EMH is based on a number of assumptions about stock markets and how they function. It asserts that markets are informationally efficient, meaning that asset prices fully reflect all available information at any given time. As a result, investors cannot consistently achieve excess returns because any new information is instantly incorporated into asset prices. Arbitrage opportunities are also not available since investors can inflate the price of an undervalued stock by buying it (or make its price fall by selling). This continuous process eliminates mispricing (i.e. stocks trade at their fair market value), making it difficult for investors to exploit market inefficiencies.

Markets that are perceived as most efficient are those exhibiting high liquidity, transparency, and rapid price adjustments. Typically, these are large cap companies (such as Microsoft or Apple) that operate in developed markets with established rules and regulations around listing and trading. Examples include major stock markets such as the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE). From an index perspective, highly efficient markets include the S&P 500 in the UK and the FTSE 100 in the UK.

On the other hand, there are certain segments of the markets that are perceived as less efficient and can offer higher and less correlated returns. Such markets include companies with micro or small market capitalisation, and those operating in less established regions such as emerging and frontier markets. These companies would typically receive less attention from global investors as information barriers are higher. As a result, the EMH does not hold to the degree it does in more efficient markets. For example, investors can exploit inefficiencies that arise from public news releases as they have a strong impact on prices, but with delays could present opportunities.

Looking at other asset classes such as foreign exchange (FX), which is more liquid than equity markets and leading market participants such as governments and banks are well informed, most efficient are major G10 currencies such as the US Dollar, the Euro, the British Pound, the Japanese Yen and the Swiss Franc. Conversely, currencies that exhibit inefficiencies due to lower liquidity levels, higher transaction costs, and information asymmetry are those in emerging markets. Examples include the Brazilian Real, the South African Rand, the Indian Rupee, and the Turkish Lira. These markets tend to be less efficient due to capital controls, political risks and central bank interventions.

Forms of Market Efficiency

The EMH explores three different forms of market efficiency.

Weak Form

The weak form of the EMH suggests that asset prices fully reflect all historical data, including prices, trading volumes and returns. However, it also admits there could be some information that is private and/or yet to be made available to the public, which may not have been priced in.

Since past performance has no predictive powers, technical analysis cannot generate consistent excess returns over the long-term as it is based on historical price movements. Nevertheless, fundamental analysis may still provide an edge if new information is not immediately reflected in prices.

Semi-Strong Form

The semi-strong form of the EMH argues that asset prices adjust instantly to any public information that becomes available such as financial statements, earnings reports, news, and economic data. For example, following the release of the monthly jobs data in the US (i.e. the Non-farm payrolls), prices adjust rapidly as the market absorbs the new information.

As a result, neither technical nor fundamental analysis would be able to produce above market returns over the long run. However, it admits that investors with access to private (inside) information may achieve abnormal returns.

Strong Form

The strong market efficiency form considers that asset prices reflect all available information including public and private (insider) and even those with inside knowledge, such as company executives cannot sustain long-term alpha. Therefore, the strong form of the EMH argues that markets are fully efficient.

EMH and Passive Investing

Since the EMH concludes that markets are efficient and it is impossible to outperform over the long-term, passive investors are key advocates for this theory. They prefer picking an index tracking fund that simply replicates the underlying holdings and performance of a specific market without trying to achieve better relative returns through taking excess risk. The below chart highlights some of the arguments for passive investing including closet indexing.

In contrast, the biggest opponents of the EMH are active investors, who believe there are market inefficiencies that can be exploited, and which could lead to above-market returns.

According to Morningstar’s Active/Passive Barometer, which is a semi-annual report that measures the performance of active funds against passive peers, only about 29% of active funds managed to beat their average indexed peer over the decade through June 2024. Furthermore, success rates were higher among areas such as real estate and bond funds and lowest among US large-cap strategies, where only 20% of funds managed to outperform over the same period. For comparison, that number was around 38% is the US small cap segment highlighting its lower efficiency.

Conclusion

Overall, since its introduction the EMH is one of the most debated theories in the financial industry and academia. While it provides a strong case for passive investing, there are a number of market anomalies that suggest that prices do not always reflect the fair value of an asset. Nevertheless, historical data shows that most active managers fail to consistently deliver excess returns, reinforcing the benefits of long-term, cost-efficient investing through index funds.‌