The Efficient Market Hypothesis Eats Itself
Markets cannot be perfectly efficient, because if they were, no one would gather the information needed to make them (more) efficient.
The last post was named Finance Theory Does Not Work, which stated, as the name reveals, that it does not—but simply through the mentioning of where finance theory sits on the hierarchy of scientific methods. Hence, we did not get much meat on our bones in understanding why finance theory does not work (i.e. does not stand up well to empirical tests). So let us devote this post to discussing one of the most common assumptions finance theory is built on. In future posts, we will dig deeper and further by going over other reasons for the theory’s shortcomings.
The assumptions finance theory is built on are usually mathematically convenient but behaviorally and sociologically naive, which makes them unrealistic.
For instance, the Efficient Market Hypothesis (EMH) assumes that all investors are rational and that prices reflect all available information. The theory was put forth in the seminal paper Efficient Capital Markets: A Review of Theory and Empirical Work by Eugene Fama, published in the Journal of Finance in 1969. In the paper, Fama defined three forms (or subsets, as he calls them) of market efficiency: the weak form, in which prices only reflect historical prices or past trading information; the semi-strong, where prices reflect all publicly available information; and finally the strong form, which reflects all information, both public and private—or, as Fama describes it, “tests concerned with whether given investors or groups have monopolistic access to any information relevant for price formation are reviewed.”
If the strong form of EMH were fully true—that all information is instantly and perfectly reflected in prices—it would mean that skill-based alpha (above-market returns) would not exist (it would only be due to luck), and there would be no reason to pay anyone to pick stocks. Because no edge in investing could come from fundamental research, technical analysis, or quant models. Nor could any benefit from insider info be derived, and active management would be a zero-sum game before fees and a negative-sum game after fees.
The fact, touched upon in an earlier post The Emotional Economic Man, that there is extensive research showing that it is nearly impossible for individual fund managers to outperform the “market” (peers and/or benchmarks) on a consistent basis net of fees—well, if that is true, would that not mean that EMH is correct? The theory is one of the reasons index investing and passive funds rose to the prominence we see today. If trying to beat the market through active stock picking is a losing game on average (as EMH states), then if you can’t beat the market, just buy the market.
This led to the creation of the world’s first index fund in 1971 by John “Mac” McQuown at Wells Fargo. Eugene Fama even consulted on the project, which was obviously and significantly influenced by, and based on, his Efficient Market Hypothesis.
Well, yes—the rise and outperformance of index funds do support the fact that markets are hard to beat. For instance, much of the available information seems to quickly be incorporated into prices, and prices are “good enough” that trying to outguess the market consistently is very difficult. This aligns with the semi-strong form of EMH.
However, market prices, as we know, can still be wrong—massively wrong. Any crisis—think dot-com bubble or the GFC in 2008—or even events such as the GameStop squeeze, are all very hard to explain with the strong form of EMH. Just because most active managers do not beat the market after fees—and that makes index funds look better relatively—does not mean all information is perfectly priced in. So indexing can work even if EMH is not entirely true.
And now we are getting to the part where it gets fascinating. Because even as passive investing proved successful in practice, it simultaneously challenged the very theory it was built on. Why? Because one way of looking at it is that passive funds free-ride on active fund managers’ “price-discovery work,” i.e. trying to find mispriced securities. So if markets were perfectly efficient (strong form of EMH), there would be no incentive to gather information. And if nobody gathers information, prices cannot be efficient—because nobody found the information, and hence the market would not have that information in the first place.
This is called the Information Paradox, or Grossman-Stiglitz Paradox, named after the researchers and authors of—probably the most profound critique of EMH—the influential paper On the Impossibility of Informationally Efficient Markets (Grossman & Stiglitz, 1980).
If there are no arbitrage opportunities because the market is in equilibrium, then there would be no arbitrage profits to make from the arbitrageur’s costly activities. Which would mean that no one would spend resources to gather information that is already “baked into” current prices.
Grossman and Stiglitz (1980) propose a model where there is an “equilibrium degree of disequilibrium.” Meaning that prices reflect the information of informed individuals—but only partially—so that those who spend resources to obtain information are compensated for that information gathered. Prices then convey information from the informed individuals to the uninformed. For example, if someone gathers information which reveals that the price of a stock should increase, then that someone bids up the price of that stock. Or the other way around—when they find information indicating the stock is overpriced, they sell and bid the price downwards. Through the price mechanism, information is publicly shared from the informed to the uninformed. Hence, a competitive market is not always in equilibrium. There needs to be enough mispricing to reward those who spend resources to uncover information.
So yes, we can definitively reject the strong form of EMH.
Firstly, as shown theoretically by Grossman & Stiglitz (1980), markets cannot be perfectly efficient—there needs to be an incentive to gather information.
Secondly, there have been studies finding that insider trading earns abnormal returns. For instance, the paper by Jeng, Metrick, and Zeckhauser (2003) found that insider purchases earn abnormal returns of more than 6% per year. This would not be possible under the strong form of EMH.
Thirdly, even Fama has indicated that the strong form does not hold in practice. You can listen to the interview with him on the podcast The Joe Walker Podcast.
And let us not forget the fact that you will be put in jail for insider trading. So, regulators definitely do not believe in the strong form of EMH.
In the end, the strong form of EMH collapses under the weight of its own logic—it demands a perfection that would erase the very forces that make markets function.
References
Fama, E.F. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, 25(2), pp.383–417.
Grossman, S.J. and Stiglitz, J.E. (1980). On the Impossibility of Informationally Efficient Markets. American Economic Review, 70(3), pp.393–408.
Jeng, L.A., Metrick, A., and Zeckhauser, R. (2003). Estimating the Returns to Insider Trading: A Performance-Evaluation Perspective. Review of Economics and Statistics, 85(2), pp.453–471.