Price Multiples
The concept of price multiples refers to ratios that compare a company’s share... Read More
Most, if not all, markets can be thought of as existing on a spectrum between perfect efficiency and complete inefficiency. This is because several factors contribute to or impede the efficiency of a market, including market participants, information availability and financial disclosure, and limits to trading.
In general, as the number and sophistication of participants within a market increase, the market becomes more efficient.
The more information market participants have, the more accurate the market’s estimates of intrinsic value, thus creating greater market efficiency. In highly efficient markets, information is provided to all market participants simultaneously, and the advantage of insiders is limited.
Arbitrage is seen as a way to improve market efficiency. Pure arbitrage usually means buying an asset in one market and selling it in another market where it has a higher price. For instance, if a security is thought to be overvalued, investors can perform a short sale, which means selling a borrowed security.
Some regulators argue that short selling can push securities down and cause market crashes. However, research generally shows that short selling actually helps market prices by letting supply and demand work efficiently. It helps in setting fair market prices.
Question
As more market participants opt for passive management over active management, market efficiency is likely to:
- Increase.
- Decrease.
- Remain unchanged.
Solution
The correct answer is B.
Passive management doesn’t typically aim to take advantage of market inefficiencies. Instead, it operates under the assumption that the market is highly efficient. Passive investors focus on reducing management fees to earn higher returns. In theory, the more popular active management is, the less effective it becomes.
As passive management gains more popularity, there are fewer active market participants searching for and profiting from price inefficiencies. This can result in a decrease in market efficiency over time.