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The Efficient Markets Hypothesis The Demise of the Demon of Chance? Stephen J. Brown NYU Stern School of Business The 19th Annual Conference on Pacific Basin Finance, Economics, Accounting, and Management

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Major developments over last 40 years Portfolio theory

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Major developments over last 40 years Portfolio theory Asset pricing theory

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Major developments over last 40 years Portfolio theory Asset pricing theory Efficient Markets Hypothesis

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Major developments over last 40 years Portfolio theory Asset pricing theory Efficient Markets Hypothesis Corporate finance

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Major developments over last 40 years Portfolio theory Asset pricing theory Efficient Markets Hypothesis Corporate finance Derivative Securities, Fixed Income Analysis

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Major developments over last 40 years Portfolio theory Asset pricing theory Efficient Markets Hypothesis Corporate finance Derivative Securities, Fixed Income Analysis Market Microstructure

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Major developments over last 40 years Portfolio theory Asset pricing theory Efficient Markets Hypothesis Corporate finance Derivative Securities, Fixed Income Analysis Market Microstructure Behavioral Finance

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The EMH was responsible for the GFC Neo-liberal policy prescriptions flow from the core theoretical belief in the superiority of unregulated markets - particularly unregulated financial markets. These claims ultimately rest on the "efficient-markets hypothesis", which, in its strongest form, claims that financial-market prices, like stock-market prices, incorporate all available information, and therefore represent the best possible estimate of asset prices. It follows, therefore, that if markets are fully efficient and prices fully informed, there is no reason to believe that asset-price bubbles are probable; and if these do occur, markets will self-correct; and that there is therefore no justification for government intervention to stop them occurring Kevin Rudd The Monthly 42 (February 2009)

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The EMH was responsible for the GFC The incredibly inaccurate efficient market theory was believed in totality by many of our financial leaders, and believed in part by almost all. It left our economic and government establishment sitting by confidently, even as a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments led to our current plight. Surely, none of this could be happening in a rational, efficient world, they seemed to be thinking. And the absolutely worst part of this belief set was that it led to a chronic underestimation of the dangers of asset bubbles breaking. Jeremy Grantham (quoted in the New York Times June 5, 2009)

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Granthams performance over GFC Sharpe Ratio Alpha (market benchmark) Alpha (Fama French 3 factor) GMO US Equity Allocation Fund; Class III Shares-0.284-0.00288 (-0.94)-0.00264 (-0.80) GMO Tobacco-Free Core Fund; Class III Shares-0.268-0.00215 (-0.71)-0.00261 (-0.81) GMO US Quality Equity Fund; Class VI Shares-0.245-0.00113 (-0.31)-0.00043 (-0.11) GMO US Quality Equity Fund; Class V Shares-0.245-0.00112 (-0.30)-0.00041 (-0.10) GMO US Quality Equity Fund; Class IV Shares-0.246-0.00116 (-0.31)-0.00045 (-0.12) GMO US Quality Equity Fund; Class III Shares-0.247-0.00121 (-0.33)-0.00050 (-0.13) GMO Tax-Managed US Equities Fund; Class III Shares-0.318-0.00473 (-1.62)-0.00435 (-1.40) GMO US Growth Fund; Class M Shares-0.276-0.00258 (-0.86)-0.00339 (-1.15) GMO US Core Equity Fund; Class M Shares-0.301-0.00388 (-1.46)-0.00392 (-1.37) GMO US Core Equity Fund; Class VI Shares-0.295-0.00353 (-1.32)-0.00355 (-1.23) GMO US Core Equity Fund; Class IV Shares-0.295-0.00357 (-1.33)-0.00359 (-1.24) GMO US Core Equity Fund; Class III Shares-0.296-0.00362 (-1.36)-0.00363 (-1.26) GMO US Intrinsic Value Fund; Class III Shares-0.353-0.00736 (-2.44)-0.00708 (-2.30) GMO US Small/Mid Cap Growth Fund; Class III Shares-0.306-0.00591 (-1.24)-0.00894 (-2.21) S&P500 Market-0.236 Data from August 07 May 09 from CRSP Mutual Funds Database

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Efficient Markets Hypothesis No traders information gives them an advantage If information is already incorporated in price

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Examples of EMH applications Weak form Efficient Markets Hypothesis Example: trading rule tests Does active management outperform passive benchmark? Semi-strong form EMH Example: Event studies What information releases are material to investors? Empirical asset pricing Example: Orthogonality condition in GMM Can we explain cross sectional dispersion in required return?

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Efficient Markets Hypothesis Tests of Efficient Markets Hypothesis Does the market efficiently process information? What is information? Estimation of parameters Does the market efficiently price risk? What determines the cross section of expected returns?

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Efficient Markets Hypothesis

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Random Walk Hypothesis

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Random Walk Hypothesis The series looks like a wandering one, almost as if once a week the Demon of Chance drew a random number from a symmetrical population of fixed dispersion and added it to the current price to determine the next weeks price Kendall (1953)

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Random Walk Hypothesis Serial Correlation tests Variance ratio tests

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Random Walk Hypothesis Serial Correlation tests Variance ratio tests Momentum Zero investment portfolio

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Random Walk Hypothesis Well established statistical properties Strong assumption of stationarity Time varying conditional expectations not allowed Neither necessary nor sufficient for EMH

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Trading rule tests of EMH Timmerman (2007) survey Nave models using past sample means hard to beat Recent financial data is most relevant Short lived episodes of limited predictability Predictability is not profitability Necessity: Do not consider all possible patterns of returns Sufficiency: Cannot profit if all markets rise and fall together

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Examining profitability Appearance of short term profitability.. at the expense of significant downside risk (Goetzmann et al. 2008) Benchmark Portfolio Socit Gnrale Jan 2008 Jrme Kerviel Nick Leeson

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An important seminal reference

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Trading Rules: Cowles 1933 Cowles, A., 1933 Can stock market forecasters forecast? Econometrica 1 309-325 William Peter Hamiltons Track Record 1902-1929 Classify editorials as Sell, Hold or Buy Novel bootstrap in strategy space Return on DJI

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Trading rule predicting sign of excess return January 1970 - December 2005 Factor-augmented AR logit based on prior 120 month rolling window Trading rule value S&P500 value

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Cowles Bootstrap Jan 1970-Dec 2005 Annualized excess fund return 2.203% Sharpe ratio of fund 0.063 Sharpe ratio of S&P500 0.049 Peseran & Timmermann (1992) p-value 4.83% Cowles bootstrap p-value 6.32%

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Standard Event Study approach 05 10152025 30 t r t1 r t2 r t3 r t4 u 01 u 11 u 21 u 02 u 12 u 22 u 03 u 13 u 23 u 04 u 14 u 24 u 05 u 15 u 25 EVENT

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Fama Fisher Jensen and Roll

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FFJR Redux

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Bottom line: is EMH useful? For whom is the EMH true? Uninformed investors with limited capital? Large well informed and well endowed investors? Does it have practical implications? Benchmark comparisons for fund investors? What information is material to investors? Useful measures of risk and investment risk premia?

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The EMH was not responsible for GFC Banks invested in beta, thinking it was alpha They borrowed to invest in market risk Significant debt exposure at cusp of crisis Banks failed to predict the collapse of the market A direct implication of the EMH