Alpha, the Capital Markets, and

the Efficient Markets Hypothesis

(Chapter 6)

Adapted from Portfolio Construction, Management, & Protection, 4e, Robert A. Strong

Copyright ©2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.

1
No matter how many winners you’ve got, if you
either leverage too much or do anything that
gives you the chance of having a zero in
there, it’ll all turn into pumpkins and mice.

Warren Buffett

2
 Outline
 Introduction
 Alpha and Portfolio Management
 Role of the Capital Markets
 Efficient Market Hypothesis
 Anomalies

3
 What is “alpha”?
 Alpha = the amount by which the market is beaten, after
adjusting for risk
 What is alpha for the market as a whole?
 Alpha for market as a whole is zero
– So, on average, portfolios are ON the SML
 Provides conceptual value of CAPM
– Regardless of whether market is efficient, it is still a zero-sum
game
 Burden of active manager
– In order to win (i.e., beat the market), someone else has to lose
 Key question = what is special about you (and about
your knowledge) that will allow you to be the one that
wins?
4
 Generating alpha
 Are there ways to consistently generate
alpha?
 See portfolio manager performance
example:

5
Portfolio Manager’s Performance:
Past Three Years

Fund
Previous Three Years: S&P 500 Manager

Compound Annual Return -4.98% -22.01%

Total Return -14.20% -52.56%

6
Portfolio Manager’s Performance:
Past Four Years

Fund
Previous Four Years: S&P 500 Manager

Compound Annual Return 0.50% -14.19%

Total Return 2.02% -45.77%

7
Portfolio Manager’s Performance:
Past Five Years

Fund
Previous Five Years: S&P 500 Manager

Compound Annual Return 3.17% -0.54%

Total Return 16.91% -2.67%

8
Portfolio Manager’s Performance:
Past Six Years

Fund
Previous Six Years: S&P 500 Manager

No. of Down Years 2 of 6 4 of 6

Compound Annual Return 3.29% -1.66%

Total Return 21.47% -9.58%

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 Generating alpha
 Would you have invested with this manager?
 Who is this manager with this horrible record?
 Warren Buffett, of course!!!
 Portfolio = investment in Berkshire-Hathaway, over
the period of 1970 – 1975
 Note: while stock price lagged market
substantially, book value per share grew faster
than market each year except 1975; this is a
metric with which Buffett is more concerned

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 Generating alpha
 As we have seen previously in discussing the EMH, value
stocks tend to outperform growth stocks
 Concomitantly, Warren Buffett has the best investment
record in history, becoming the 2nd richest man in the world
in the process
 However, as we have just now seen, although value wins
on average, over the long run, it does not win perfectly
consistently!
 Instead, the markets tend to cycle, with different styles of
investment performing well at different times

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 Book to Market as a Predictor of Return:
Value (positive ) tends to outperform Growth (negative )

25%
Annualized Rate of Return

20%

15%

10%
Value
5% Growth

0%
1 2 3 4 5 6 7 8 9 10
High Book/Market Low Book/Market

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 Rolling Annualized Average 5-year Difference
Between the Returns to Value and Growth Composites:
The Market cycles between Value and Growth,
50%
But Value Wins on Average
40%

30%
Relative Difference

20%

10%

0%

1990
1986

1988
1977
1978

1983
1984

1989
1973
1974
1975
1976

1979
1980
1981
1982

1985

1987

1991

1997
1996
1993
1994
1992

1995
-10%

-20%
Year

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 Empirical Regularities:
Sources of alpha
 Three categories that tend to outperform over the long run:
– Value stocks vs. Growth stocks
– Size: Small caps tend to outperform large caps
– Momentum: stocks with momentum (earnings or price) tend to beat stocks
without momentum
 However, the payoffs to all of these tend to cycle!
– A typical portfolio manager, being judged on a quarter-by-quarter basis, would
have been fired long before if he had the same record as Buffett for 1970 –
1975!
– (In fact, he fired himself during this period!)
 None of these beats the market perfectly consistently
– A typical portfolio manager would need to try to cycle along with the market, in
order to keep from ever lagging too far behind it

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 Empirical Regularities:
Sources of alpha
 Beating the market consistently would require some sort of
rotation strategy in order to profit from the type of securities
that are performing well in the given type of market
 But - combination of “fat tails” and “volatility clustering”
(discussed previously) can cause problems!
– Best performance for a given style is likely to follow closely on the
heels of its worst performance, and much of the movement for the
style is likely to come in a relatively short burst (thus, if you miss it,
it’s gone)
– E.g.: 40% of the stock market gains for the entire decade of the
1980’s occurred during a mere 10 trading days !
– So efforts to cycle with the market and keep from falling too far
behind it also make it much more difficult to beat the market!

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 Capital Market Theory
 Capital market theory springs from the
notion that:
– People like return
– People do not like risk
– Dispersion around expected return is a
reasonable measure of risk

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 Role of the Capital Markets
 Definition
 Economic Function
 Continuous Pricing Function
 Fair Price Function

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 Definition
 Capital markets trade securities with lives of
more than one year
 Examples of capital markets
– New York Stock Exchange (NYSE)
– American Stock Exchange (AMEX)
– Chicago Board of Trade
– Chicago Board Options Exchange (CBOE)

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 Economic Function
 The economic function of capital markets
facilitates the transfer of money from savers
to borrowers
– e.g., mortgages, Treasury bonds, corporate
stocks and bonds

19
 Continuous Pricing Function
 The continuous pricing function of capital
markets means prices are available moment
by moment
– Continuous prices are an advantage to
investors

– Investors are less confident in their ability to get

a quick quotation for securities that do not trade
often
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 Fair Price Function
 The fair price function of capital markets
means that an investor can trust the
financial system
– The function removes the fear of buying or
selling at an unreasonable price

– The more participants and the more formal the

marketplace, the greater the likelihood that the
buyer is getting a fair price

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 Efficient Market Hypothesis
 Definition
 Forms of Efficiency
– Weak Form
– Semi-Strong Form
– Strong Form
 Security Prices and Random Walks

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 Definition
 The efficient market hypothesis (EMH) is the
theory supporting the notion that market prices are
in fact fair
– Under the EMH, security prices fully and fairly (i.e.,
without bias) reflect all available information about the
security
– Since the 1960’s, the EMH has been perhaps the most
important paradigm in finance
– Whether markets are efficient has been extensively
researched and remains controversial

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 Informational Efficiency
 Informational efficiency is a measure of
how quickly and accurately the market
reacts to new information
– This is the type of efficiency with which the EMH
is concerned
– The market is informationally very efficient
 Security prices adjust rapidly and fairly accurately to
new information
 However, as we’ve already seen, the market is still
not completely efficient

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 Forms of Market Efficiency
 Eugene Fama’s original formulation of the Efficient
Market Hypothesis established three forms of market
efficiency, based on the level of information reflected in
security prices:
1. Weak form = prices reflect all past market level (price
and volume) information
2. Semi-strong form = prices also reflect all publicly
available fundamental company and economic
information
3. Strong form = prices also reflect all privately held
information that would affect the value of the company
and its securities

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 Weak Form
 Definition
 Charting
 Runs Test

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 Definition
 The weak form of the EMH states that it is
impossible to predict future stock prices by
analyzing prices from the past
– The current price is a fair one that considers
any information contained in the past price data
– Charting techniques are of no use in predicting
stock prices

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 Definition (cont’d)
Example

Which stock is a better buy?

Stock A

Current Stock Price

Stock B

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 Definition (cont’d)
Example (cont’d)

Solution: According to the weak form of the EMH, neither

stock is a better buy, since the current price already
reflects all past information.

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 Charting
 People who study charts are technical
analysts or chartists
– Chartists look for patterns in a sequence of
stock prices
– Many chartists have a behavioral element

30
 Runs Test
 A runs test is a nonparametric statistical
technique to test the likelihood that a series of
price movements occurred by chance
– A run is an uninterrupted sequence of the same
observation
– A runs test calculates the number of ways an observed
number of runs could occur given the relative number of
different observations and the probability of this number
– These tests have provided evidence in favor of weak
form efficiency

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 Conducting A Runs Test

Rx
Z

where R  number of runs
2n1n2
x 1
n1  n2
2n1n2 (2n1n2  n1  n2 )

 n1  n2 
2
(n1  n2  1)
n1 , n2  number of observations in each category
Z  standard normal variable
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 Semi-Strong Form
 The semi-strong form of the EMH states that
security prices fully reflect all publicly
available information
– e.g., past stock prices, economic reports,
brokerage firm recommendations, investment
advisory letters, etc.

33
 Semi-Strong Form (cont’d)
 Academic research supports the semi-
strong form of the EMH by investigating
various corporate announcements, such as:
– Stock splits
– Cash dividends
– Stock dividends
– Examined through “event studies”
 This means investors are seldom going to
beat the market by analyzing public news

34
 Semi-Strong Form (cont’d)
 Market seems to do a relatively good job at adjusting a
stock’s valuation for certain types of new information
• Determining how much the new info. will change the stock’s value
and then adjusting the price by an equivalent amount
 This is what event studies examine
• But it does seem to have problems developing an overall
valuation for a stock in the first place
• E.g., What is the correct value for IBM as a whole is a very difficult
question to answer, but how much IBM’s value should change if it
is awarded a specific new contract is much easier to determine

35
 Semi-Strong Form (cont’d)
 Burton Malkiel points out that two-thirds of
professionally managed portfolios are consistently
beaten by a low-cost index fund
– Suggests that securities are accurately priced and that
in the long run returns will be consistent with the level of
systematic risk taken
 Supports semi-strong form of the EMH
– Also would suggest that portfolio managers do not
possess any private information that is not already
reflected in security prices
 Supports the strong form of the EMH

36
 Strong Form
 The strong form of the EMH states that
security prices fully reflect all relevant public
and private information
 This would mean even corporate insiders
cannot make abnormal profits by using
inside information about their company
– Inside information is information not available
to the general public

37
 Security Prices and
Random Walks
 The unexpected portion of news follows a
random walk
– News arrives randomly and security prices
adjust to the arrival of the news
 We cannot forecast specifics of the news very
accurately

38
 Anomalies
 Definition
 Low PE Effect
 Low-Priced Stocks
 Small Firm and Neglected Firm Effect
 Market Overreaction
 Value Line Enigma
 January Effect
39
 Anomalies (cont’d)
 Day-of-the-Week Effect
 Turn-of-the Calendar Effect
 Persistence of Technical Analysis
 Behavioral Finance
 Joint Hypothesis Problem
 Chaos Theory

40
 Definition
 A financial anomaly refers to unexplained
results that deviate from those expected
under finance theory
– Especially those related to the efficient market
hypothesis

41
 Low PE Effect
 Stocks with low PE ratios provide higher returns
than stocks with higher PEs
– And similarly for high P/B (hence lower Book/Market)
stocks
 Supported by several academic studies
 Conflicts directly with the CAPM, since study
returns were risk-adjusted (Basu)
 Related to both semi-strong form and weak form
efficiency

42
 Low-Priced Stocks
 Stocks with a “low” stock price earn higher
returns than stocks with a “high” stock price
 There is an optimum trading range

43
Small Firm and Neglected Firm
Effects
 Small Firm Effect
 Neglected Firm Effect

44
 Small Firm Effect
 Investing in firms with low market
capitalization will provide superior risk-
adjusted returns
 Supported by academic studies
 Implies that portfolio managers should give
small firms particular attention

45
 Neglected Firm Effect
 Security analysts do not pay as much
attention to firms that are unlikely portfolio
candidates
 Implies that neglected firms may offer
superior risk-adjusted returns

46
 Market Overreaction
 The tendency for the market to overreact to
extreme news
– Investors may be able to predict systematic
price reversals
 Results because people often rely too
heavily on recent data at the expense of the
more extensive set of prior data

47
 The Value Line Enigma
 Value Line (VL) publishes financial information on
about 1,700 stocks
 The report includes a timing rank from 1 down to 5
 Firms ranked 1 substantially outperform the market
 Firms ranked 5 substantially underperform the
market
 Victor Niederhoffer refers to Value Line’s ratings as
“the periodic table of investing”

48
 The Value Line Enigma
 Changes in rankings result in a fast price
adjustment
 Some contend that the Value Line effect is merely
the unexpected earnings anomaly due to changes
in rankings from unexpected earnings
 Nonetheless, Value Line’s successful record is
evidence in support of the existence of superior
analysts who apparently possess private
information

49
 January Effect
 Stock returns are inexplicably high in
January
 Small firms do better than large firms early
in the year
 Especially pronounced for the first five
trading days in January

50
 January Effect (cont’d)
 Possible explanations:
– Tax-loss trading late in December (Branch)
– The risk of small stocks is higher early in the
year (Rogalski and Tinic)

51
 January Returns by Type of Firm

Average Average January Average January

January return minus average return after
return monthly return in rest adjusting for
of year systematic risk
S&P 500
Companies
Highly 2.48% 1.63% -1.44%
Researched
Moderately
4.95% 4.19% 1.69%
Researched
Neglected 7.62% 6.87% 5.03%
Non-S&P 500
Companies
Neglected 11.32% 10.72% 7.71%
Source: Avner Arbel, “Generic Stocks: The Key to Market Anomalies,” Journal of Portfolio Management, Summer 1985, 4–13.

52
 Day-of-the-Week Effect
 Mondays are historically bad days for the
stock market
 Wednesday and Fridays are consistently
good
 Tuesdays and Thursdays are a mixed bag

53
 Day-of-the-Week
Effect (cont’d)
 Should not occur in an efficient market
– Once a profitable trading opportunity is
identified, it should disappear
 The day-of-the-week effect continues to
persist
 However – there are confounding effects
between the levels and the volatilities of
returns across different days
54
 Turn-of-the-Calendar Effect
 The bulk of the return comes from the last
trading day of the month and the first few
days of the following month
 For the rest of the month, the ups and
downs approximately cancel out

55
 Persistence of
Technical Analysis
 Technical analysis refers to any technique in
which past security prices or other publicly
available information are employed to
predict future prices
 Studies show the markets are efficient in the
weak form
 Literature based on technical techniques
continues to appear but should be useless

56
 Behavioral Finance
 Concerned with the analysis of various
psychological traits of individuals and how these
traits affect the manner in which they act as
investors, analysts, and portfolio managers
 Growth companies will usually not be growth
stocks due to the overconfidence of analysts
regarding future growth rates and valuations
 Notion of “herd mentality” of analysts in stock
recommendations or quarterly earnings estimates
is confirmed

57
 Chaos Theory
 Chaos theory refers to instances in which
apparently random behavior is systematic or even
deterministic
– under Mauboussin’s theory of the market as a complex
adaptive system, then we would expect to see chaotic
dynamics
 Econophysics refers to the application of physics
principles in the analysis of stock market behavior
– e.g., an investment strategy based on studies of
turbulence in wind tunnels
– Includes use of multifractal models

58
 Are Markets Rational?
 This question always faces a joint hypothesis
problem:
– Tests of EMH are always dual tests of both market
efficiency and the specific asset-pricing model assumed
– Market efficiency
 Is the stock’s price equal to its true value?
– Asset pricing model used (CAPM, APT, etc.)
 What is the stock’s true value?
 Never known for sure
 “The question of value presupposes an answer to the question,
of value to whom, and for what?” – Ayn Rand
 E.g., the value of Apple stock would be different to Steve Jobs
than to any other investor 59
 Are Markets Rational?
 Related issue – what is information?
– “Information is that which causes changes” – Claude
Shannon (father of information theory)
– So, if something causes the markets to move, then by
definition, it must be information, and vice versa
– From this perspective, the market is neither efficient nor
inefficient, it just is
 So, are the markets efficient or rational?
– Ultimately, difficult to answer categorically
– Key question is not whether or not the markets are efficient
– this is a side issue – but how investors should act, given
how the markets work
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