Market Efficiency and
Performance Evaluation
Global Financial Management
Campbell R. Harvey
Fuqua School of Business
Duke University
charvey@mail.duke.edu
http://www.duke.edu/~charvey
1
Overview


Market Efficiency
» Theory of efficient markets
» Types of market efficiency
» Evidence
» Implications
Measuring Mutual Fund Performance
» Performance measures
2
The Net Present Value Rule
Investment
Projects
Primary
Market
Secondary
Market
Competitive
Advantage
Competition
in Capital Markets
NPV of
project
=
PV cash
inflows
-
Initial
Investment
-
Value of
liability
-
Price of
shares
NPV of
financing
=
Money
raised
NPV of share
purchase
=
Value of
shares
NPV of projects can be positive
NPV of transactions is zero
Prices are "fair"
3
Three Forms of Market Efficiency
Prices reflect all
information from
past prices
Prices reflect all
publicly available
information
Prices reflect all
relevant available
information
Technical Analysis
is valueless
Fundamental
Analysis is
unprofitable
Insider Trading
is unprofitable
Weak Form
Semi-strong Form
Strong Form
4
Weak Form Efficiency: Tests
A market is weak form efficient if current prices
reflect all information contained in past prices
and price movements.
Implications
» Past prices cannot predict price movements in the future.
» Trading rules based on technical analysis cannot yield
superior returns.
Tests
» Tests of correlation of prices.
» Tests of trading rules.
5
Head and Shoulders Pattern
Stock
Price
Time
6
Bollinger Bands
IBM Bollinger Bands
110
105
100
Price ($)
95
90
85
80
75
70
12/31
02/19
04/09
05/29
07/18
09/06
7
Studies on the Correlation of Markets
Elton/Gruber, 15.2, p. 409
8
Weak Form: Summary
Evidence in favor
Implications:
 Technical rules are useless.
 If the price of a stock has just gone up or down, then it does not
follow that it will go up or down in the future.
Reason:
 If technical rules worked, everyone would use them. As a result
they would not work anymore.
This does not imply:
 Prices are “uncaused”.
 Markets do not behave according to rules.
 Investors are incompetent.
9
Semi-Strong Form Efficiency
A market is semi-strong form efficient if all
publicly available information is reflected in market prices.
Implications:
 Market reacts to information about companies’ fundamentals
» Macroeconomic news.
» News on earnings.
 Price adjustments are fast and appropriate: no systematic
under/overshooting after announcement.
Tests:
 Event studies of price reactions to news announcements.
 Tests of asset pricing models
» Joint hypothesis problem
10
Semi-Strong Form Evidence
Event Studies










Earnings announcements.
Dividend announcements.
Leading indicators.
Stock splits.
Accounting changes.
Mergers and acquisitions.
Corporate reconstructions.
Block sales.
Rights issues.
Share tips.
11
Macroeconomic Announcements
Time
Content of Annoucement
8.30 am Consumer Price Index
Durable Goods Orders
Employment
Gross National Product
Housing Starts
Merchandise Trade Deficit
Leading Indicators
Producer Price Index
Retail Sales
Time
Content of Annoucement
9.15 am Industrial Production
Capacity Utilization
10.00 am Business Inventories
Construction Spending
Factory Inventories
NAPM Survey
New Single-Family Home Sales
Personal Income
2.00 pm Federal Budget
no fixed time: Instalment Credit
12
Reaction to Macroeconomic
Announcements
Question
» How quickly do markets absorb information? Is the reaction
appropriate?
Method
» Investigate reaction of futures markets on Treasury bonds, dollar and
deutche marks traded on CBOT and CME.
Results
» Almost all the price adjustment takes place in the first minute after
the announcement (eg for
– CPI between 8.30 and 8.31.
» Later adjustments cannot be predicted from earlier reactions
– No systematic over or underreaction;
» No profitable trading on news.
13
Semi-Strong Form Conclusions
Evidence
 Unbiased evaluation by investors.
 Pre-announcement information leakage.
 Rapid adjustment to new information.
Implications
 Fundamental analysis is valueless
– Unless it is original, or it incorporates private
information.
 Check if price has already moved
– If not, must be able to act fast!
14
Strong Form Efficiency
A market is strong form efficient if all relevant information
(public or private) is reflected in market prices.
Implications:


Analysts’ knowledge doesn’t help.
No profits from insider trading.
Tests:


Profitability of trading on inside information.
Performance of fund managers.
15
Strong Form Evidence



Fund managers’ peformance:
» Mutual funds
» Pension funds
Specialists and insiders
» Market makers
» Corporate officers
Analysts’ skills
» Advisory services
» Internal research
» Transactions analysis
Analyze mutual fund performance
– Implications for semi-strong form efficiency
16
Mutual Fund Styles






Aggressive Growth
Growth
Growth-Income
Income-Growth
Balanced
Income
17
Style and Beta Risk
Beta Risk and Investment Style
1.6
1.4
1.2
Beta
1
0.8
0.6
0.4
0.2
0
Aggressive Growth
Growth
Growth-Income Income-Growth
Balanced
Income
Style
18
Style and Volatility
Volatility and Investment Style
10
Volatility
8
6
4
2
0
Aggressive Growth
Growth
Growth-Income Income-Growth
Balanced
Income
Style
19
Style and Average Returns
Average Excess Returns and Investment Style
Excess Returns
1.5
1
0.5
0
(0.5)
Aggressive Growth
Growth
Growth-Income Income-Growth
Balanced
Income
Style
20
Jensen’s Alpha

From the CAPM:
Erit   i  i Erit 

Any expectation can be written as a realized value plus a shock:
rit  rft  i rmt  rft   it

Check intercept of the regression model:
rit  rft  i rmt  rft   it
If fund managers have no additional information we should
have:   0
21
Measuring Mutual Fund
Performance
Return
of Fund
•
•
•
rf  
rf
1.0
Beta
22
Historical Performance of Mutual
Funds
Mutual Fund Performance
Jensen (1969)
40
35
32
30
Frequency
30
28
25
20
15
10
10
5
0
10
3
1
0
-5
-4
-3
1
-2
-1
0
1
T-statistics
2
3
0
0
4
5
23
Distribution of Alphas
Distribution of Alphas: 74 Funds, 1968-1993
Bansal and Harvey (1995)
30
26
24
25
21
19
20
16
15
11
10
8
6
CAPM alpha
11 11
0
1
7.5:9
2
6:7.5
1.5:3
0:1.5
-1.5:0
-3:-1.5
1 1
4.5:6
3
3:4.5
3
-6:-4.5
-7.5:-6
00 00
-9:-7.5
0
2
-4.5:-3
5
r* alpha
24
Distribution of t-Statistics
Distribution of T-Statistics: 74 Funds, 1968-1993
Bansal and Harvey (1995)
50
44
40
31
30
28
25
20
T-ratio CAPM
7.5:9
6:7.5
4.5:6
3:4.5
1 21 00 00 00
0:1.5
0
-1.5:0
0
-3:-1.5
2
7
-4.5:-3
-6:-4.5
-7.5:-6
00 00 00
-9:-7.5
0
7
1.5:3
10
T-ratio r*
25
Portfolio Manager Ability
Stock Picking
Specific Stock Selection Ability
Excess
Return
of Fund
}
Excess Return
of Market

Stock-picking ability: Can the manager identify which stocks
will outperform the market or the industry?
26
Portfolio Manager Ability
Market-Timing
Market Timing Ability
Excess
Return
of Fund
Linear
Regression
}
Excess Return
of Market

Market-timing ability: Can the manager identify turning points
between bull and bear markets?
27
Perfect Market-Timing Ability
Perfect Market Timing Ability
Excess
Return
of Fund
Linear
Regression

{
Excess Return
of Market
28
Sharpe Ratios


Idea: use the Capital Market Line
» If markets are efficient and CAPM holds, return/risk ratio
should be the same for all assets
The Sharpe Ratio is the ratio of excess returns to volatility:
Si 

ri  rf
i
Compare the Sharpe Ratio for a particular fund to that of the
market (or appropriate benchmark):
Sm 
rm  rf
m
29
Ex-Post Sharpe Ratios
E[ri]
Ex post Sharp ratio
higher than the market
CML
ABC
M
rf
XYZ
Ex post Sharp ratio
lower than the market
i
30
The Treynor Measure


Idea: use the security market line:
» If markets are efficient and CAPM holds, all assets should lie
on SML
The Treynor Measure is the ratio of excess returns to
systematic risk:
Ti 

ri  rf
i
Compare the Yreynor Measure for a particular fund to that of the
market (or appropriate benchmark):
Tm 
rm  rf
m
31
The Treynor Measure
E[ri]
Ex post Treynor index
higher than the market
SM
L
AB
C
M
rf
XY
Z
Ex post Treynor index
lower than the market
i
32
Graham-Harvey Measures



Create a portfolio of S&P500 futures contracts and a money
market account that matches the volatility of the particular
mutual fund.
Lever the mutual fund volatility to match the S&P500 futures
volatility by borrowing or lending.
In each case, compare the returns of the two portfolios.
33
Graham-Harvey Measure
E[ri]
SML
M
ABC
rf
XYZ
Ex Ante Efficient
Frontier (Risky Assets)
i
34
Mutual Fund Performance:
New Evidence
Issue
» Investigate forecasting ability of individual managers: “hot”
hands and “icy” hands in stock picking.
Test
» Does the past performance of a fund predict its future performance:
correlation between returns.
Results
» Underperformance is more persistent than outperformance of the
market.
» Past return data help to predict the future relative performance of the
fund.
» Even funds with “hot hands” do only marginally better than the market.
Conclusion
» Invest in index funds, not in actively managed funds.
Source: Hendricks et. al. (1993)
35
Performance Persistence
Consecutive Years of Probability of Superior
Superior Performance Performance Next Year (%)
1
50.4
2
52.0
3
53.4
4
55.8
5
46.8
36
Investment Newsletter
Performance



Graham and Harvey (1995) study the performance of
recommendations of 200 investment newsletters.
Given the evidence on market efficiency, what should we
expect?
Even if the newsletter writers have inside information - should
we expect to make money by following their recommendations?
37
Performance of All Newsletters
Performance of 257 Newsletter Strategies
Graham and Harvey (1995)
0.5
Average annual return
0.4
S&P 500
0.3
T-Bills
0.2
0.1
0
(0.1)
(0.2)
0
0.1
0.2
0.3
Annualized standard deviation
0.4
38
Performance of Long-Lived
Newsletters
Performance of Newsletter Strategies:
In Existence for More than Four Years
Graham and Harvey (1995)
Average annual return
0.6
0.4
S&P 500
T-Bills
0.2
0
(0.2)
(0.4)
0
0.1
0.2
0.3
Annualized standard deviation
0.4
39
Ability to Time Bull Markets
Monthly S&P500
Return
Performance of Newsletter Strategies
Graham and Harvey (1995)
20%
10%
Fitted Regression
Line
0%
-10%
-20%
-30%
0%
10%
20%
30%
40%
50%
60%
Percent of letters which increased weights in each month
70%
40
Ability to Time Bear Markets
Performance of Newsletter Strategies
Graham and Harvey (1995)
Monthly S&P500
Return
20%
10%
Fitted Regression
Line
0%
-10%
-20%
-30%
0%
10%
20%
30%
40%
50%
60%
Percent of letters which decreased weights in each month
70%
41
Implications of Market Efficiency
There Are No Money Machines
Hence:

Don’t pay a premium for acquisitions unless you can add value.

Don’t use the capital structure to speculate on market
movements:
» international borrowing to speculate on currencies.
» Debt structure, swaps, and timing to speculate on interest
rates.

Don’t manipulate accounts to boost earnings.
42
Implications of Market Efficiency
Trust Market Prices
Hence:

Treat market prices as values; assume price changes reflect
information or the value of management actions.

Use the market’s free forecasts’ to value projects using market
currency and interest rate forecasts.
43