(51).---PORTFOLIO MANAGEMENT-EMPIRICAL TESTING OF THE EMH-(3)-.

Testing of the strong from of the EMH

The strong form could be tested by looking at the returns earned by people with private information, such as corporate insiders and specialists. If these people do earn superior returns, this would represent an anomaly for the strong form
Corporate insiders, such as directors and specialists, have been shown to earn superior returns, demonstrating that private information is not immediately reflected in stock prices. This was particularly the case with purchase transactions. Directors have assess to information within the corporate while specialists have privileged access to the order book on the NYSE.

Tests on value line rankings of stocks have indicated that rankings by value line advisory service predict future returns, but any excess return rapidly disappears after the rankings are published. In addition a, it is not possible to gain excess returns after transaction costs.

Tests based on analysts’ recommendations have had mixed conclusions. Generally, stocks on which recommendations are made will experience any abnormal price movement very rapidly on the same day of the recommendation.
Tests based on the returns earned by money managers indicate that a small majority achieved better risk-adjusted return than the market before transaction costs. However, the majority are not able to beat a buy and hold policy after transaction costs.

Generally, apart from directors and specialists who earn consistently superior returns, the tests tend to support the strong form of the EMH.

Testing of the EMH in overseas markets.

Tests of the EMH in European countries such as the UK have consistently portrayed a picture similar to that in the US, even for countries with very narrow markets. This suggests that it is appropriate to view European markets as having the same amount of informational efficiency as the US.

Implications of the EMH .

Technical analysis.

The implication of the EMH for technical analysis does not work if the EMH holds. It is not possible to make abnormal profits based on analysis of past market information.

Fundamental analysis,

For a fundamental analyst, it implies that if all you can do is analyze past economic events and information, it is very difficult to earn superior risk adjusted results. A buy and hold policy will perform just as well.

Nevertheless, the fact that research tests have shown that it is possible for some investors to make superior profits shows that analysis can reap benefits. This cannot be done merely by processing available information, but by using such information to estimated long-run variables that will derive returns in the future. The analyst would need to be superior to others for this to give superior profits over time.
In addition, it may be possible to take advantage of some of the anomalies noted above. For example, an analyst may concentrate on neglected stocks, hoping to acquire additional information by dint of extra effort.

Investors with superior information.

An investors with access to superior analysts should follow their recommendations. The best place to take advantage of superior analysis is in second-stocks, which are sufficiently liquid but not exhaustively researched.
An analyst will only offer superior returns if he can consistently outperform a randomly selected portfolio with equal risk levels through time.

Investors without superior information.

When an investor does not have access to superior analysts, he should establish his risk preferences and invest in / maintain a diversified portfolio (on a worldwide basis) which has this level of risk. This can be done through the separation theorem, by investing an appropriate amount in the market and the rest in risk-free assets. The portfolio should be rebalanced as appropriate.
Key objectives beyond this will be to minimize transaction costs by tax planning, reducing turnover of stocks, and buying liquid stocks (to reduce liquidity costs).

Use of index funds.

If capital markets are efficient and there are no superior analysts, then an investors objective should be to match the market, while minimizing any costs of research and trading. This will be the overall highest return for the investor.

Index (or market) funds are designed to track the market by buying a portfolio of shares that follow a market index closely, while reducing costs to the minimum. Such funds may follow a broad- based domestic equity index or a more specific index, such as an overseas market or small cap stocks.

This is the case for both US and European investment, since it was noted above that European markets also have a high level of efficiency.