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Research: Testing the Efficient Market Hypothesis

FPG Research examines how fund managers have greater potential to add value over direct investors into the New Zealand and Australian equity markets.

Sunday, November 8th 1998, 12:00AM

by Philip Macalister

The Efficient Market Hypothesis (EMH) contends that the expected returns from investing are commensurate with the risk assumed – no more, and no less. Discussions of this theory have postulated three forms of efficient market: weak, semi-strong and strong.

Weak EMH
Studies discussing the weak form of EMH have argued that the past history of price information is of no value in assessing future changes in price.

The EMH does not state in any of its three forms that abnormal returns (either high or low) cannot be achieved occasionally on a random basis. However, EMH does contend that consistently abnormal returns in excess of those commensurate with the risk involved are not possible in a truly efficient market.

Semi-strong EMH
The semi-strong form of EMH states that information which is available publicly, such as price, earnings, dividends, stock split announcements, new product developments, financing difficulties, and accounting changes, cannot be used to earn returns consistently in excess of those warranted by the level of risk assumed in the investment decision. This is the most widely-held belief among investment analysts and academics.

The semi-strong form of EMH holds that publicly-available information is reflected immediately in the price of a security, and is therefore of no value in selecting securities and achieving abnormal returns. A market which incorporates all publicly-available information quickly into security prices is said to show the semi-strong form of efficiency. (Semi-strong efficiency encompasses the weak form of EMH, because the historical information which comprises the latter is part of this publicly-available information.)

Strong EMH
The strong form of the EMH states that no information, whether public or private, can be used to consistently achieve returns in excess of those warranted by the level of risk assumed.

This is the information set to which the majority of investors have no access, because of constraints which include time, resources, and so forth. If investors do obtain access to all the information available publicly and privately about a security, the costs associated with acquiring this information may be greater than the excess returns which could be achieved through the use of the information.

Advantages of professional investment management
This is where the advantage lies with professional investment management teams. Investment managers, with their dedicated time and research resources, are able to obtain in-depth market information about a security cost-effectively. Investors in these managed investments are able to take advantage of this information, to which they would not generally have access themselves.

Although investment managers operating with ‘active’ investment mandates may not be able to add consistently significant value when equity markets are growing at a steady rate, their superior information sets can prove invaluable in times of market volatility. This is because the superior information can enable the investment manager to manage downside risk more effectively (to minimise the effects of the falling market on returns to investors in their products).

As noted above, the most common belief among investment analysts and academics is that the semi-strong form of EMH holds for equity markets – that no publicly-available information can be used when trading to consistently achieve returns above those warranted by the level of risk taken.

However, the same amount of information is not available publicly for every security in the market. The information available about any given company can depend on factors such as the company’s market capitalisation, how recently it was listed, or the market in which the company trades. This leaves an interesting test for market efficiency, particularly for managed investment fund for which a considerable amount of data is available.

Although limited research on this subject is available, historical trends suggest that some managed investments with active investment mandates are able to add value to investors under volatile market conditions.

Graph one below shows the performance of four leading actively-managed New Zealand equity trusts and of the NZSE Gross Index (representing the market) over the two years from July 1995 to July 1997.

Graph One: Comparative performance of four New Zealand equity trusts and NZSE Gross Index

July 1995 – July 1997

The performance of the NZSE Gross Index in graph one shows that the New Zealand equity market was experiencing steady growth over the period. Under these conditions, investment managers found it difficult to outperform the market on a consistent basis, due to operational costs and different risk objectives.

However, the EMH analyses rates of return compared to the level of risk taken to achieve that return. Graph two below compares the performance of six actively-managed New Zealand equity trusts against the market security line over the four years to 31 August 1998. The market security line, represented by the NZSE Gross Index and the 90 Day Treasury Bill Rate, shows the trade-off between the risk and expected return for a product in its relevant market.

Graph Two: Risk/return analysis of six New Zealand equity trusts compared to the New Zealand equity market security line, four years to 31 August 1998

Graph two shows that over this period, at least two active managers, Armstrong Jones and New Zealand Funds Management, had risk/return ratios above the market security line. This indicates that they were able to achieve returns higher than the Index for the amount of risk taken over the four years, and that these products were able to add significant value to their investors’ monies.

This outperformance can be attributed to the quality and timeliness of the market information which the managers of these products obtained through their research. The costs of this research (and subsequent outperformance) passed on benefits to the products’ investors at a minimal cost compared to the potential cost of the investors researching the information for themselves.

To test these results on another market, the same analysis was performed on 50 Australian-domiciled equity trusts available for promotion in New Zealand, using a longer time period because these Australian products had longer market histories (from September 1989 to August 1998). Graph three below shows this analysis. The market security line in this case is represented by the All Ordinaries Accumulation Index and the Government 13 week Treasury Notes Rate.

Graph Three: Risk/return analysis of Australian equity trusts compared to Australian equity market security line, nine years to 31 August 1998

Graph three shows that the results were very similar to those discovered above for New Zealand equity trusts. At least seven of the 50 Australian equity trusts had risk/return ratios above the market security line, indicating that their investment managers were able to achieve returns in excess of the market for the amount of risk taken.

This demonstrates that the Australian equity market cannot hold the strong form of market efficiency. If the market was strong in efficiency terms, all the investment managers would possess the same information, and none would be able to rise above the market security line on a risk-adjusted basis. By default therefore the Australian equity market must be semi-strong.

These analyses have shown that it is possible to outperform the New Zealand and Australian equity markets on a risk/return basis. This indicates that these markets hold at most the semi-strong form of efficiency.

If these markets were strong, all public and private information about the securities in the market would be available, and outperformance of the market security line would not be possible. If these markets were weak, all managers would be able to achieve returns using publicly-available information above the level of risk taken.

Although this appears positive for the managed investments industry, it should be noted that the industry is relatively new in New Zealand and still in an early stage of development. However, as investors clamour for information, and attempt to be the first to act on this information, they make the market more efficient. If enough of this activity occurs, all information about an equity security will be reflected in its market price. Therefore, the fact that a number of investors are not believers in EMH results in actions which help to make equity markets more efficient.

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