Question

Your investment client asks for information concerning the benefits of active portfolio management. She is particularly interested in the question of whether active managers can be expected to consistently exploit inefficiencies in the capital markets to produce above-average returns without assuming higher risk.

The semi-strong form of the efficient market hypothesis asserts that all publicly available information is rapidly and correctly reflected in securities prices. This implies that investors cannot expect to derive above-average profits from purchases made after information has become public because security prices already reflect the information’s full effects.

a. Identify and explain two examples of empirical evidence that tend to support the EMH implication stated above.

b. Identify and explain two examples of empirical evidence that tend to refute the EMH implication stated above.

c. Discuss reasons why an investor might choose not to index even if the markets were, in fact, semi-strong-form efficient.

Short answer

The correct answer is:

a. Empirical events to support: not comparable returns to money managers, immediate response of stock to relevant public information and difficulty in identifying price trends to earn superior risk adjusted returns.

b. Empirical events to refute: simple portfolio strategies such as low P/E stocks, small firms in January and post earnings announcements, stock price drift etc.

c. An investor might stay away from indexing because investor might want to tailor a portfolio to specific tax consideration.

Step-by-step solution

Empirical evidence to support

(i) The portfolio managers do not typically earn comparable returns.

(ii) Stocks typically respond immediately to publically available relevant news

(iii) Identifying price trends to earn superior risk adjusted returns is difficult.

Empirical evidence to refute

(i) Simple portfolio strategies that would have provided high risk adjusted returns in past. These include P/E stocks, high book to market ratio stocks, small firms in January and firms with very poor stock price performance.

(ii) Post –earning announcement

(iii) Stock price drift and

(iv) Intermediate term price momentum

Reasons why an investor might not choose to index

Even in the above scenario, the investor might not choose to index as he might want to tailor portfolio to specific tax consideration or risk management.