The Efficient Markets Hypothesis
Review of Empirical Financial Economics
Stephen J. Brown
NYU Stern School of Business
Major developments over last 40
years
 Portfolio theory
Major developments over last 40
years
 Portfolio theory
 Asset pricing theory
Major developments over last 40
years
 Portfolio theory
 Asset pricing theory
 Efficient Markets Hypothesis
Major developments over last 40
years
 Portfolio theory
 Asset pricing theory
 Efficient Markets Hypothesis
 Corporate finance
Major developments over last 40
years
 Portfolio theory
 Asset pricing theory
 Efficient Markets Hypothesis
 Corporate finance
 Derivative Securities, Fixed Income Analysis
Major developments over last 40
years
 Portfolio theory
 Asset pricing theory
 Efficient Markets Hypothesis
 Corporate finance
 Derivative Securities, Fixed Income Analysis
 Market Microstructure
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
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)
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)
Grantham’s 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
Efficient Markets Hypothesis
 No trader’s information gives them an advantage
E  rt  | it , t   E  rt  | t   0
 If information zit is already incorporated in price


E rt   E  rt  | t  zit  0
t
Brown, Stephen J. 2011 The Efficient Markets Hypothesis: The demise of the Demon of Chance? Accounting and
Finance 51 79-95. Available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1508702
Examples of EMH applications


E  rt   E  rt  | t  zt  0
t
 Weak form Efficient Markets Hypothesis
1

zt  0
1

 Example: trading rule tests
 Does active management outperform passive benchmark?
1

 Example: Event studies
zt  0
 What information releases are material to investors? 
1
 Semi-strong form EMH
 Empirical asset pricing
sell
hold
buy
bad news
no news
good news
 Example: Orthogonality condition in GMM
zt  "instruments "
 Can we explain cross sectional dispersion in required return?
Efficient Markets Hypothesis


E  rt   E  rt  | t  zt  0
t
 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?
Efficient Markets Hypothesis


E  rt   E  rt  | t  zt  0
t
Random Walk Hypothesis


E  rt   E  r  rt  0
Random Walk Hypothesis


E  rt   E  r   rt  E  r   0
“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 week’s price”
Kendall (1953)
Random Walk Hypothesis


E  rt   E  r   rt  E  r   0
 Serial Correlation tests
 Variance ratio tests
Random Walk Hypothesis


E  rt   E  r   rt  rt   0
Zero investment portfolio
 Serial Correlation tests
 Variance ratio tests
 Momentum
Random Walk Hypothesis


E  rt   E  r  rt  0
 Well established statistical properties
 Strong assumption of stationarity
 Time varying conditional expectations not allowed
 Neither necessary nor sufficient for EMH
Trading rule tests of EMH


E  rt   E  rt  | t  zt  0
t
1

zt  0
1

sell
hold
buy
 Timmerman (2007) survey
 Naïve 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
Examining profitability
 Appearance of short term profitability ..
Portfolio
Nick Leeson
Société Générale Jan 2008
Jérôme
Kerviel
Benchmark
 at the expense of significant downside risk
(Goetzmann et al. 2008)
An important seminal reference …
Trading Rules: Cowles 1933
 Cowles, A., 1933 Can stock market forecasters forecast?
Econometrica 1 309-325
 William Peter Hamilton’s Track Record 1902-1929
 Classify editorials as Sell, Hold or Buy
Eˆ [rt   E  rt  |  t ] t  3.5%
Return on DJI
 Novel bootstrap in strategy space
 1

 t  0
 1

41 sell
74 hold
140 buy
Trading rule predicting sign of excess return
January 1970 - December 2005
Trading rule value
S&P500 value
Factor-augmented AR logit based on prior 120 month rolling window
Cowles Bootstrap
Jan 1970-Dec 2005
Annualized excess fund return
Sharpe ratio of fund
Sharpe ratio of S&P500
Peseran & Timmermann (1992) p-value
Cowles bootstrap p-value
2.203%
0.063
0.049
4.83%
6.32%
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?
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