Most, if not all, markets can be thought of as existing on a spectrum between perfect efficiency and complete inefficiency. A number of factors contribute to or impede the efficiency of a market, including market participants, information availability and financial disclosure, and limits to trading.

Market Participants

In general, as the number and sophistication of participants within a market increase, the market becomes more efficient.

Information Availability and Financial Disclosure

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 at the same time and the advantage of insiders is limited.

Limits to Trading

The act of arbitrage is believed to increase market efficiency. Pure arbitrage typically involves buying an asset in one market and selling the same asset in a different market at a higher price. When market participants believe a security is overvalued they can perform a short sale – or, the sale of a borrowed security. Some regulators argue that short selling puts inefficient downward pressure on securities leading to market crashes, but research generally shows that short selling helps supply and demand effectively determine market prices.

Question

As more market participants opt for passive management over active management, market efficiency is likely to:

A. Increase

B. Decrease

C. Remain unchanged

Solution

The correct answer is B.

Passive management does not generally try to exploit market inefficiency but instead assumes that the market is highly efficient and passive investors will ultimately earn higher returns by reducing management fees as much as possible. At least, in theory, the popularity of active over passive management has an inverse relationship to its effectiveness. Therefore, as passive management becomes more common, there are fewer active market participants to find and profit from price inefficiencies, and market efficiency is likely to decrease.

Reading 38 LOS 38c:

Explain factors that affect a market’s efficiency