E Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management.

Question 1

If markets are weak-form efficient

Answer 1

technical analysis does not consistently result in abnormal profits.

Technical analysis based only on own
prices will not be profitable.

Question 2

If markets are semi-strong form efficient

Answer 2

fundamental analysis does not consistently result in abnormal profits. However, fundamental analysis is necessary if market prices are to be semi-strong form efficient.

• Technical analyses will not be profitable.
• Fundamental analyses based only on
public information will not be profitable.
– Active management based only on publicly
available information is not profitable.
– Passive management is the only sensible
alternative.
• Fundamental analyses based on private
information may be profitable.
– Private information may include insider
information.

Question 3

If markets are strong-form efficient

Answer 3

active investment management does not consistently result in abnormal profits.

Even if markets are strong-form efficient, portfolio managers can add value by establishing and implementing portfolio risk and return objectives and assisting with portfolio diversification, asset allocation, and tax minimization.

• No technical or fundamental analyses
will be profitable.
• Only passive management is sensible.

Question 4

Modern Definition for Market Efficiency:

Answer 4

Market are efficient if traders cannot
make abnormal profits by collecting,
processing and trading on information.

demonstrate the limitations to fully efficient markets?: Processing new information entails costs and takes at least some time, so security prices are not always immediately affected.

If market prices are efficient there are no returns to the time and effort spent on fundamental analysis. But if no time and effort is spent on fundamental analysis there is no process for making market prices efficient. To resolve this apparent conundrum one can look to the time lag between the release of new value-relevant information and the adjustment of market prices to their new efficient levels. Processing new information entails costs and takes at least some time, which is a limitation of fully efficient markets.

In an efficient market all stocks are properly priced and reflect all publicly available information. Therefore, individual selection of stocks is not important the only thing that is relevant is the portfolio’s beta.

Which of the following is a limitation to fully efficient markets?
:gains to be earned by information trading can be less than the transaction costs the trading would entail. Market prices that are not precisely efficient can persist if the gains to be made by information trading are less than the transaction costs such trading would entail.

Portfolio managers cannot eliminate systematic risk (i.e., market risk) thru the use of diversification. Portfolio managers should try to eliminate unsystematic portfolio risk.

Question 5

Abnormal Profits Market Definition

Answer 5

Abnormal profits = consistently beating

the market on a risk-adjusted basis