Source: Tavaga Research
What is the Efficient Market Hypothesis (EMH)
The efficient market hypothesis (EMH) is a theory which states that all securities are fairly priced, and the price reflects (or it anticipates) the present, past, and future information, both publicly and privately available in the market.
The efficient market hypothesis assumptions require information about factors affecting security to be quickly made available and reflected in the stock prices.
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Different Forms of Efficient Market Hypothesis
Different forms of EMH stem from different forms of efficiency in markets.
Eugene Fama, one of the foremost proponents of passive investing in the seventies, had proposed three forms of market efficiency: The weak form, the semi-strong form, and the strong form.
Now, what is the weak-form of the efficient market hypothesis? When defining this efficiency of the efficient market hypothesis, Fama assumed that all the past information, both quantitative and qualitative, are fully reflected in security prices. As a result, if a market is weak-form efficient, the technical analysis, that is, analyzing past data will not generate abnormal returns.
The semi-strong-form market efficiency assumes that all the information in the marketplace, both past, and present, is fully reflected in security prices. Thus, if a market is semi-strong-form efficient, technical and fundamental analysis will not generate abnormal returns.
For example, in the recent monetary policy committee meeting in November 2019, the market had expected a repo rate cut. That meant the market had already incorporated the present data of rate-cut expectations.
The strong-form market efficiency makes an assumption that all the information, public and private, is already incorporated in securities prices. Thus, if a market is strong-form efficient, even the insiders cannot make an abnormal profit.
The efficient market hypothesis weak-form is the easiest to achieve. Markets, across the world, become at least weak-form market efficient and even semi-strong-form efficient to an extent, as they mature.
But strong-form market efficiency is near-impossible to achieve and only exists in theory so far. The efficient market hypothesis meaning is mostly played out by weak-form and semi-strong-form efficiencies in real life.
The Random Walk Theory
The efficient market hypothesis in finance is the opposite of the random walk theory, coined by the French mathematician Louis Bachelier in 1900. The theory states that stock prices follow a random path and is independent of the past price, hence the past, future, or for that matter, any information, cannot predict the market performance.
The supporters of active management discard the theory of EMH and are of the opinion that markets are inefficient. Again, there have been many studies, which prove there are anomalies in the markets, such as the” January effect”. It shows that returns on securities are usually higher in January than in other months. The January effect is still in effect, despite being observed 25 years ago.
There are many such anomalies, classified under categories such as calendar anomalies, fundamental anomalies, and technical anomalies. The anomalies make us ask, “Is the efficient market hypothesis valid?”, casting strong doubts on how practical its applications are.
The Middle Line
Data exists supporting both efficient markets and anomalous markets. However, anomalies have also been critiqued because of various assumptions they make and their data mining (finding statistical relevance in a given time period to prove a hypothesis) which may not be foolproof. Markets are neither completely efficient nor anomalous. Both the characteristics are present in most markets, to varying degrees.
Active vs Passive Investing
The debate pitting active investing against passive investing is never-ending.
However, the efficient market hypothesis has put the trillions-of-rupees-worth active management industry at risk.
Active managers, on average, have underperformed the benchmark or have provided returns less than their passive-investing peers.
Performance comparison between SBI Nifty 50 ETF (Passive) and SBI Large & Midcap fund (Active)
But as we know, investing in the markets is a zero-sum game and for every gain, there will be a concurrent loss. For every trade in the markets, there are two parties, the buyer and the seller. While some of the active managers will generate positive alpha, some will lose out on positions and underperform the benchmark.
Passive investing makes things easier for the investors as they don’t have to spend energy and resources on finding a good investment manager. It supports the desire to separate the money from the traditional form of investments and have exposure to the markets.
Passive investing hinges on what is meant by the efficient market hypothesis as it espouses the availability of information, a vital need in passive investing. Active investing managers usually have to work extra-hard on securing information to get an edge and achieve alpha.