(52).---Summary of EMH.

Summary of EMH

• Definition – market where prices respond rapidly to new information, such that expected returns equal required returns for all investors.
• Requirements for an efficient market.
  - Competing investors react to information quickly.
  - Large number of analysts competing
  - Random information
• Weak from – prices reflect all available market information. Empirical evidence supports this form generally, indicating that it is not possible to achieve superior returns after transaction cost.
• Semi-strong form – prices reflect all publicly available information. Tests suggest that there may be return anomalies that disprove this level.
• Strong form – prices reflect all information, both public and private. Tests indicate that, apart from specialists and directors, other insiders do not earn consistently superior returns.
• Implications for technical analysis – the weak form suggest that technical analysis is invalid.
• Implications for fundamental analysis – it is not possible to earn superior returns just by processing past information. An analyst must be superior at estimating how key variables will change in the future.
• Testes of the weak form.
  - Statistical tests of independence, based on auto correlation and runs tests.
  - Tests of specific trading rules.
• Tests of the semi-strong form
  - Statistical tests of independence, based on auto correlation and runs tests
  - Tests of specific trading rules.
• tests of the semi-strong form
  - aiming to predict future returns based on currently available information, based either on time series data
  - aiming to use new information to make superior returns on stocks(event studies.)
• Market anomalies – these are where there are predictable returns form the market. If this is the case, it suggests that the EMH is invalid. Examples include the following.
  - High dividend yield stocks have given high returns
  - High default spreads have been followed by high returns.
  - Positive earning surprises have been followed by high returns.
  - The January effect where stocks earn low returns in December and high returns in January
  - Small companies have given higher returns (size effect).
  - Neglected stocks have given higher returns.
  - High book to price (low price to book )stocks have given higher returns.
• Overall conclusion on efficient markets. _ most tests of market efficiency support the theory, in its weak and semi – strong forms. There appear to be some stock market and semi-strong forms. There appear to be some stock market anomalies that may refute the EMH. However, it is usually the case that anomalies may earn superior risk adjusted returns before transaction costs but will not after transaction costs.
• Performance of securities analysts – although some analysis appear to have the ability to earn superior risk adjusted returns, the majority are unable to outperform a buy and hold strategy.
• Use of index funds – if markets are efficient then it is not a good idea to try and beat the market. Instead, investors should use index funds that track a particular index, reducing costs to a minimum.
• Role of portfolio manager in efficient markets
  - Identify risk preferences of the client.
  - Select a portfolio based on risky and risk-free assets that matches the client’s needs.
  - Fully diversify the portfolio of risky assets.
  - Minimize transaction costs. This is done by tax efficient investment, reducing trading turnover and minimizing liquidity costs by trading in liquid securities.